BUSINESS ECONOMICS (PART – 4)

WORKING OF PRICE MECHANISM VOL - 3

(LAW OF DEMAND)

1. INTRODUCTION
Hello students, I welcome you to the series on Business economics. The
topic of this lecture is working of price mechanism in continuation with
our last lecture. In the last lecture we studied the various factors
determining the demand and their impact on demand. The objectives
of this lecture are to make you understand the Law of demand,
exceptions to law of demand and the change or shift in the demand
curve.

The law of demand says that “ceteris paribus” which means when
means other things remaining the same or other things remaining
constant, the price and the demand of the commodity share an inverse
relationship which means when the price of the commodity increases
its demand decreases and when the price of the commodity decreases
its demand increases while other factors remain constant.
Now when we talk about these other things, what are these other
things? These other things are nothing but the factors which determine
the demand which we discussed in the last lecture other than price.
These factors are price of related commodities, income of consumers,
consumer’s expectation and consumers’ taste and preferences.

The law of demand as described in the words of Prof. Marshall is “the

amount demanded increases with a fall in price and diminishes with a
rise in price”.

which means when the price of the commodity increases its demand
decreases and when the price of the commodity decreases its demand
increases.

The law of demand as explained in the words of Prof. Meyers is “under

the same conditions of demand, the quantity of a commodity which
will be purchased tends to vary inversely with its price”, which means
demand decreases with increased price and demand increases with
reduced price.
which means there is an inverse relationship between the demand and
price of the commodity and the other factors remain constant.

So we have noticed that Prof. Marshall has highlighted the inverse

relationship between demand and price of the commodity whereas
Prof. Meyers has given emphasis to both inverse relationship between
demand and price of the commodity as well as role of other factors
determining the demand of the commodity.

So these factors remain constant.

Now we have understood that the law of demand highlights the human
behavior which is the human tendency of purchasing large quantity of
product at reduced price and purchasing less quantity of product at
higher price. So this tendency or human behavior has formulated a law
which is known as law of demand.
 2. EXAMPLE OF LAW OF DEMAND
Now let us quickly consider an example which shows the application of
law of demand.

The assumptions here in this example are:

-There is no change in consumer’s income.

-There is no change in price of related commodities.

-There is no change in consumer’s taste and preference.

-There is no new substitute of the commodity available in the

market.

-There is no expectation of change in price of the commodity in

near future.

-There is no change in population.

-There is no change in existing wealth of the consumers.

In this example we will discuss the price and quantity demanded for
tomatoes. Look at this demand schedule.

When the price of the tomatoes was Rs. 20, the quantity demanded in
kgs for tomatoes was 5, when the price of the tomatoes reduced to 15
Rs. the quantity demanded for tomatoes increased to 10 kgs and so on.

Look at this graph -

X axis represents the quantity demanded for tomatoes and Y axis
represents the price for tomatoes.

Point A represents the lowest demand of tomatoes at the highest price

whereas point D represents the highest demand for tomatoes at the
lowest price.

The demand for tomatoes increased with the decrease in price of the
tomatoes and the demand for tomatoes decreased with the increase in
the price of the tomatoes while other factors remain the same. So we
have noticed that when the price of the tomatoes increased its
demand decreased and when the price of the tomatoes decreased its
demand increased while other factors affecting the demand remained
constant.

So this was an example of law of demand where price and quantity

demanded shares inverse relationship while other factors affecting the
demand remain constant.

As we have seen in this graph the demand curve slopes downwards.

Now why does demand curve slopes downwards?

The downwards slope of demand curve is because of the law of

demand that is when the price of the commodity increases the demand
decreases and when the price of the commodity decreases its demand
increases. So the downward slope is because of the inverse relationship
between the price and the demand of the commodity.

This negative or downward slope of demand curve may be understood

through two different approaches, these two approaches are
traditional approach and modern approach.
According to Professor Marshall, the downward slope of demand curve
is because of the law of diminishing marginal utility but in the view of
modern economists it is because of the income and substitution effect.

Let us understand the various causes of downwards slope of the

demand curve.

These various causes are

 The law of diminishing utility effect

 Change in number of consumers
 Price effect
 Substitution effect
 Income effect
Let’s talk about the Law of diminishing marginal utility effect. When a
person increases the consumption of a product while keeping
consumption of other products constant, there is a decline in the
marginal utility that person derives from consuming each additional
unit of that product, this effect is known as the law of diminishing
utility.

We will study the marginal utility and diminishing utility later under
the topic consumer’s equilibrium which is again a part of price
mechanism but for the time being for understanding the law of
diminishing utility, let’s consider this example.

3. EXAMPLE OF LAW OF DIMINISHING MARGINAL UTILITY

In this example we are talking about a buffet-style restaurant which
provides its customers an option to eat unlimited at the price of $5.

So this Indian traveler who goes there, this is by the way a Chinese
restaurant which operates in Chicago, USA. This Indian traveler goes
there and purchases the coupon of $5 to eat unlimited and he proceeds
towards the buffet table.
This traveler is already tired of sightseeing and he is quite hungry, this
traveler is fond of chicken so he takes the first plate and fills it up with
orange chicken, pepper chicken, chicken sattae and other chicken
delicacies. So he gulps away all the food since he is quite hungry and
he rates the food 9 on the scale of 10 as he was quite hungry, so his
major concentration was on eating the food. He takes up the next
plate and proceeds to the buffet table and he fills the plate up with
sushi and other noodles.

Now he rates the food 7 on 10 as he is quite satisfied and his hunger

has tamed a little bit. Now he proceeds with the third plate and fills it
up with different varieties of fruits. His hunger is completely satisfied
and his appetite is full with spending only $5 for unlimited food, he
cannot consume more food and now he has reached the saturation
level and if he eats more, he will get sick. So he has consumed the
food till it was useful to him that is till the time the food did not make
him sick.

With every added plate the utility and the level of satisfaction was
dropped down and finally he reached the saturation level and stopped
the consumption completely.

Same is the case with law of diminishing utility. The consumer keeps
on consuming till there is utility attached at lesser price and ultimately
when the consumer reaches the saturation level; he stops the
consumption even if the product is offered at a lesser price.

This was the effect of law of diminishing utility that is till the point of
equilibrium, the quantity demanded is higher at lesser price and after
that the demand decreases even at the constant price.
 4. WHY LAW OF DEMAND OPERATE?

Yet another reason why law of demand operates or why the demand
curve slopes downwards is the change in number of the customers.

With the decrease in price of the commodity,

new consumers start purchasing that commodity and the old consumers
starts purchasing added quantity of the product but when the price of
the commodity will increase, the new consumers will stop buying that
commodity and the old ones will reduce the consumption of that
commodity.

Let’s taken an example to understand this, A Ltd. manufacture

calculators and it sold 10,000 calculators at the price of Rs. 1000 per
piece, out of these 10,000 customers, 2000 customers showed their
loyalty towards A Ltd. and purchased more calculators.
When A Ltd. reduced the price of these calculators to Rs. 900, at the
same time 5000 new customers purchased the calculators from A Ltd.
at this reduced price of Rs. 900.

Considering the increase in demand of the calculators, the manager at

A Ltd. became overconfident and he increased the price of the
calculators to Rs. 1050. As a result of this, 5000 new customers did not
show up again and the footfall of the old customers at the retail outlet
of A Ltd. reduced to 500 old customers.
Another reasons why law of demand operates is the Price effect.

When the price of the commodity increases its demand decreases and
when the price of the commodity decreases its demand increases. So
the old consumer’s starts purchasing more and the new consumers
start purchasing that product.

The next cause for the downward slope of the demand curve is the
substitution effect.

We have discussed about the example of tea and coffee as substitutes.

When the price of tea increases, the demand for coffee increases and
when the price of coffee increases, the demand for tea increases.

This is the substitute effect and the reason why the demand curve
slopes downwards.

Now let’s talk about the Income Effect as the other reason for the
downward slope of the demand curve or the application of law of
demand.

When the income of the consumer’s increases the price of the

commodity decreases and the demand of that particular commodity
increases, this is because the customer has increased purchasing power
and with increased income he can save money and purchase the added
quantity of that particular product.

For example when the income of an individual was Rs. 1000, he was
purchasing 10 meters of cloth and when his income increased to Rs.
2000 while other things remain constant, he made some savings and
started purchasing 15 meters of cloth.
Together substitution and income effect results in price effect which
means increased demand at reduced price and reduced demand at
increased price while other things remain constant.

The main reason why law of demand operates is the law of diminishing
utility and the different uses of the particular commodity.

5. EXCEPTIONS TO LAW OF DEMAND

But there are some exceptions to law of demand. Let’s understand

what all these exceptions to law of demand are, there are situations
when increased demand at reduced price and decreased demand at
higher price while other things remaining constant or the law of
demand is not applicable.

These exceptions are:

1. Inferior goods

2. Conspicuous consumption

3. Conspicuous necessities

4. Expected change in price of the commodity in the future

5. Ignorance of consumers

6. Abnormal situations

7. Change in consumer’s taste and preferences

Now let’s talk about the inferior good as exception to law of demand,
when the price of the inferior good decreases.

Its demand does not increase because the consumer goes for the better
quality of the product with the increased purchasing power.
With the increase in income of the consumer the demand for inferior
goods decreases this is known as griffin’s paradox.

The examples of inferior goods are coarse cloth and coarse grain.

Let’s discuss this example of inferior goods which I came across.

Two economists Robert Jensen and Nolan Miller at Harvard's Kennedy

School conducted a study on the inferior goods.

They conducted a field experiment for five months. In this experiment

they randomly selected some households and handed over a voucher to
them which provided subsidy on the purchase of their primary staple
diet.

Based on the earlier analysis of these two economists, they identified

Hunan in south China with rice as the staple food and Gansu in the
north China, with wheat as staple food.

They used the consumption survey they gathered before, during and
after imposing the subsidy.

It was found that poor households in Hunan exhibited giffen behavior

with respect to rice, i.e. lesser price of rice through the experimental
subsidy caused households to reduce their demand for rice and when
this subsidy was removed the household showed the opposite effect,
whereas in Gansu, the evidence was somewhat weaker, segregation of
households on the basis of poor and not so poor was difficult first of all
and the households were not so poor to consume only the staple diet.
Also the staple food that is wheat had limited substitution possibilities.
 6. EXCEPTIONS OF LAW OF DEMAND (CONSPICUOUS
COMMODITIES AND CONSPICUOUS NECESSITIES)

In my opinion this is the best practical example of giffen behavior,

let’s talk about the other exception to law of demand which is
conspicuous commodities.

The law of demand is not applicable in case of costly items like

diamonds and gold

because such items are purchased by the wealthy group of people, so

they consume it any way even if the price is high the demand remains
high.

So when the price of diamond is high the wealthy people will purchase
the diamond because that is their status symbol. The next category is
conspicuous necessities.
The conspicuous necessities are car, television, refrigerator etc, so the
demand will not increase or decrease with the rise or fall in the price
of these commodities.

The law of demand is not applicable when the price of commodity is

expected to rise or fall in the future.

For example gold is purchased at higher price even if it is expected

that the price of gold will rise in the future.

Similarly if the price of petrol is expected to rise in future, the current

demand of petrol will increase.

In the same way consumers may hold on to their purchase for gold if
the price of gold is expected to fall in the future.

The next category to exception of law of demand is the Ignorance of

the Consumers.
The demand of the commodity will remain constant if the consumers
are ignorant towards competitive prices of the commodity or if the
consumer thinks that high priced goods are of high quality then he will
keep on purchasing the commodity at the higher price.

The next category is Abnormal Conditions, abnormal situations like

war, natural calamities, famine or riots make the law of demand
ineffective. Under such conditions, the consumer will purchase the
items at higher price.

The next category is change in preferences of the consumers that is

the change in habit, taste, fashion trends, likes, dislikes and
preferences of the customers make the law of demand ineffective.

So these were the exceptions to law of demand.

7. CHANGE OR SHIFT IN DEMAND

Let’s proceed with the next topic for this lecture which is the Change
or shift in demand.

The increase or decrease in the price of the commodity results in

extension or contraction of demand whereas demand increases or
decreases because of the impact of other factors on the demand
except the price.
Look at this diagram of change or shift in demand.

This is the diagram showing the change or shift in demand, the

extension or contraction of demand or the increase or decrease in
demand results in change or shift of the demand.

The moment along the demand curve is caused by the change in price
whereas shift in demand curve is caused by the factors other than the
price of the commodity.

The extension of demand is due to the downwards movement of the

demand curve whereas the contraction of demand is due to the upward
movement of the demand curve. The increase in demand is due to the
downward shift in demand curve whereas decrease in demand is due to
the upward shift in the demand curve.
Now let’s talk about the extension or contraction of the demand. The
extension of demand is due to the fall in price of the commodity, the
demand for commodity increases with the fall in its price resulting in
extension of demand while other factors other than price remains
constant.

Look at this demand schedule

when the price of the notebook was Rs. 5, 15 notebooks were

purchased but when the price of the notebooks decrease to Rs. 2, the
purchase of notebooks increase to 25.
Look at this graph; look at this movement of demand along the demand
curve from point A to point B.

Point A indicates lesser demand at higher price whereas point B

indicates increased demand at lesser price.

Look at this downward movement along the demand curve which

caused extension of demand due to change in price.

The contraction of demand is due to the rise in price of the

commodity.
The demand for the commodity decreases with the rise in price
resulting in contraction of demand while factors other than price
remain constant.

Look at this demand schedule, when the price of the notebooks was
Rs. 2, 25 notebooks were purchased but when the price of the
notebooks increased to Rs. 5, the purchase of notebooks decreased to
15.
Look at this graph; look at this movement of demand along the demand
curve from point B to point A.

Point A indicates lesser demand at higher price whereas point B

indicates increased demand at lesser price.

Look at this upward movement along the demand curve which caused
contraction of demand due to change in price.

8. INCREASE OR DECREASE IN DEMAND

Now let’s talk about the increase or decrease in demand, when the
price of the commodity remains same, more quantity is demanded for
that commodity due to the change in factors other than price, this is
termed as increase in demand.

These other factors affecting demand are:

-Increase in Income of consumer.

-Increase in Price of related commodities.

-Change in Consumers' taste and preferences.

-Change in population.

-Change in existing wealth of the consumer and

-Expectation of change in future price of the commodity.

The demand curve in this case shifts towards the right hand side.
Let us consider this example.

Look at this demand schedule, when the price of the notebooks was
Rs. 3, 20 notebooks were purchased but with the increase in quality
standards, the demand for notebooks at the same price that is Rs. 3
increased to 25 notebooks.

Now look at point A and B, look at this shift in demand curve due to
increase in demand.
The demand curve shifted towards right that is from D to D1 and D to
D2.

Now let’s talk about the decrease in demand.

When the price of the commodity remains same and less quantity is
demanded for that commodity due to change in factors other than
price, it is termed as decrease in demand.

These other factors affecting demand are:

-Decrease in Income of the consumer.

-Fall in Price of substitutes.

-Fall in Consumers taste and preference.

-Change in population.

-Change in existing wealth of the consumer

-Expectation of change in future price of the commodity.

The demand curve in this case shifts towards the left hand side.

Let us consider this example, look at this demand schedule.

When the price of the notebook was Rs. 3, 25 notebooks were

purchased but with the decrease in quality standards, the demand for
notebooks at the same price that is Rs. 3 decreased to 20 notebooks.
Look at point R and S; look at this shift in demand curve due to the
decrease in demand.

The demand curve shifted towards left that is from D to D1 and D to

D2.

Here is a comparative chart that will help you understand the

extension and contraction and increase and decrease in demand.
Look at this comparative chart, extension of demand means due to
decrease in price the demand for the commodity increases while other
factors remains constant.

Increase in demand means demand of the commodity increases due to

the factors affecting demand other than the price of the commodity.

Contraction of demand means due to increase in the price, the demand

for commodity decreases while other factors remain constant.

Decrease in demand means demand of the commodity decreases due to

factors affecting demand other than the price of the commodity.
In the case of extension of demand, the downward movement of
demand curve is noticed, in case of increase in demand, demand curve
shifts towards right hand side.

In case of contraction of demand, upward movement of demand curve

is noticed, in case of decrease in demand, the demand curve shifts
towards left hand side.
The cause for extension of demand is fall in price, the cause for
increase in demand is change in factors other than price like increase
in income of the consumers.

The cause for contraction of demand is rise in price, the cause for
decrease in demand is change in the factors other than the price like
decrease in the income of the consumers.

Look at these diagrams to compare the extension, contraction,

increase and decrease in demand.

This is the diagram showing extension of demand.

This is the diagram showing increase in demand.

This is the diagram showing contraction of demand.

This is the diagram indicating decrease in demand.

So now we have understood the reasons for the shift or change in the
demand curve.

To conclude I would say that it is very important for the managers as

well as business graduates to understand the law of demand because
the law of demand helps in determining the price of the commodity.

The impact of price on increase or decrease in demand can be

understood easily through the law of demand.
The management can analyze the flexibility of increasing or decreasing
the price of the commodity on the basis of knowledge of law of
demand and they can also understand the impact of demand through
the law of demand.

The finance minister makes use of law of demand by imposing tax on

higher priced goods like conspicuous commodities which we discussed
in this lecture as exceptions to law of demand.

Because the demand of these goods will not go down even if the tax is
imposed on higher prices of such commodities but when tax is imposed
on normal goods, their price will increase and ultimately their demand
will go down.

Agricultural sector contributes a lot to the Indian economy. If the good

crop fails to increase the demand, then the farmers cannot reap the
advantage of the good crop. This factor can also be analyzed through
understanding the law of demand.

In this context, it is very important for all the economic agents to

understand the law of demand to contribute better to the Indian
economy. Thank you.