DETERMINANTS OF DEMAND

The following are the determinants of demand (factors which influence demand)

1.  Price:  Price influences the demand for a product.  Generally when price rises, demand falls and vice versa.

2.  Income:  Income and demand have a positive relationship. When income increases, demand increases and when income decreases, demand decreases.

3. Consumers tastes and preferences:  Consumer’s tastes and preferences can influence the demand for a product.  Generally when consumer’s tastes and preferences change, the demand also changes.

4.  Price of substitutes:  Price of substitutes can influence the demand for a product; For instance a change in the price of coffee can have an impact in the demand for tea.

5.  Price of compliments:  Price of complimentary goods influence the demand for a product.  For instance, when the price of petrol increases, the demand for vehicles may fall.

6.  Customs, traditions and fashion: Customs, traditions and fashion influence the demand for products.  For instance during marriages and festivals it is customary and traditional to wear new clothes and jewels.  Likewise change in fashion influences the demand for products.

7.  Changes in supply of the commodity: any change in the supply of goods influences the demand for commodities.  If any shortage is predicted in future, then the demand for the product increases.

8.  Weather conditions:  Weather conditions influence the demand for products. For instance in cold and rainy weather the demand for coffee increases and during summer, the demand for ice creams and juice increase.

9.  Population:  Quantitative and qualitative changes in population influence the demand for products.  For instance, when the size of population increases the demand for necessaries automatically increase.

10.  Government policy:  Government policies influence the demand for products.  When the government levies higher taxes on products, their price automatically increase, their by reducing the demand.  On the other hand subsidies can help to reduce the price their by increasing the demand.

The laws of returns to scale

Laws of returns to scale explain the physical relationship between input and output in the long run.  In other words, it explains the behavior of output when all inputs vary in the same proportion.

There are three stages of returns to scale.

1.  Increasing returns to scale- Output increases by a greater proportion than the increase in input.

2.  Constant returns to scale-Output increases in same proportion as increase in input.

3.  Diminishing returns to scale-Output increases in a lesser proportion than the increase in input.

The three stages can be understood with the help of the following table.

The laws of returns to scale  can be explained with the help of a diagram as follows.

In the above diagram, the scale of input is measured on the X-axis and the marginal product is measured on the Y axis.  From point I to R the Marginal product increases depicting the increasing returns to scale.  From R to C the marginal product remains constant which depicts the constant returns to scale and Segment CD shows that the marginal product diminishes depicting the diminshing returns to scale 

The law of increasing returns to scale is due to Economies of scale.  Economies of scale refer to the advantages of large scale production. It can be divided into:

1. Internal economies which arise within the firm as a result of increasing the scale of output of the firm.  It includes:

a)  Technical economies- large firms can afford research & buy sophisticated equipment.

b)  Managerial economies- Large firms employ specialist managers to improve efficiency.

c)  Financial economies-large firms are financially more stable and can raise finance easily.

d)  Risk bearing economies- As firms grow, more products spread the risk over more markets.

e) Marketing economies-Large firms can efficiently market the products.

2.  External economies are those economies which accrue to all the firms in an industry as the industry expands.  External economies include the following.

a)  Cheaper raw material and capital equipment

b) Technological external economies

c)  Development of skilled labour.

d)  Growth of ancillary industries.

e)  Better transportation and marketing facilities

f)  Development of information services

The Law of Diminishing returns to scale is due to dis-Economies of scale.

Internal dis-economies are due the following reasons.

a)  Lack of co-ordination

b)  Loose control

c)  Lack of proper communication

d)  Lack of identification

External dis-economies include the following.
1.  Excessive pressure on transport facilities

2.  Dis-economies of air pollution & water pollution.

3.  Shortage of funds.

4. Increasing risks and marketing problems.

5.  Rise in the price of factors of production.

Cost Concepts

Cost of production can be defined as the expenses incurred in the production of a commodity by a firm. The rewards in the form of rent, wages, interest and profit given to the factors of production form the cost of Production.

Types of Cost: 

    1.  Explicit cost:  refers to cost incurred on payment made for the purchase of factors of production, for the production of a good.  It includes rent wages, payment for raw materials, interest, expense on transport, advertisement etc.

2. Implicit Cost:  are cost of self owned and self employed resources.

3.   Opportunity Cost:  refers to the cost of next best alternative sacrificed in order to produce that good.

4. Real cost:  refers to all efforts, services and sacrifices made in the production of a commodity.

5.   Private Cost: also called money cost refers to cost incurred by a firm in the production of a commodity.  It includes wages, expenses on material, electricity, rent, transport, insurance premium, tax etc.

6.    Social Cost:  refers to the cost of producing good to the society as a whole.  For example, deforestation causes soil erosion, flood , pollution caused by factories vehicles etc.

Exceptions to the law of demand

The law of demand is subject to the following exceptions.

1.  Giffen good:  A Giffen good is a special type of inferior good on which people spend a major portion of their income.  It owes its name to Sir Robert Giffen who found a unique behaviour among the labourer’s in England during the 19^th century.  They consumed Meat and bread and when the price of bread increased they consumed more of it since the price of bread was cheaper compared to meat. When the price of bread fell, their real incomes increased and they wanted a variety in their diet and so they consumed less of bread and started consuming meat. This unique behaviour is called “Giffen paradox”

2.  Veblen Effect: American economist Thorstein Veblen observed that the rich people would buy more expensive items like Jewellery, costly cars and Bungalows to show their status.  They would buy less of it when price of these items fell because others could afford it. This is called “The Veblen effect”.

3.  Speculation:  In a stock market when the share price of a company raises more people buy the stock to make windfall gains and when share price of a particular company falls, very few people purchase.

4.  Necessaries:  The law of demand doesn’t hold good in case of necessaries.  In case the price of salt rises people still buy the same quantity and not less. In case a shortage is foreseen, then the demand for salt rises in spite of its price rise.

5.  Brand loyalty:  Brand loyalty on the part of consumers ensures that the demand doesn’t fall when the price of such goods rise.

6.  Ignorance of consumers:  Consumers’ ignorance that high price goods are better quality goods also is an exception to the law of demand.

Price elasticity of demand

The responsiveness or sensitivity of demand to a given change in the price of a commodity is called Price elasticity of demand.

The price elasticity of demand can be classified as follows:

1.      Perfectly Elastic Demand:  When a small fall in the price of a commodity results in infinite quantity demanded or a small rise in price results in zero demand, it is a case of perfectly elastic Demand.  In this type of elasticity of demand the demand curve is parallel to the X axis as is shown in the diagram. The Price elasticity of demand is equal to infinity.

2.     Perfectly Inelastic Demand:  In this type of elasticity of demand, whatever may be the change in the price of a commodity; the demand remains constant and hence the demand curve is parallel to the Y axis.  The Price elasticity of demand is equal to zero.

The above mentioned cases rarely occur in the real world. They are just studied as a part of theory.

3.     Relatively Elastic demand:  When a small change in price results in more than proportionate change in the quantity demanded, it is called relatively elastic demand.  For instance, a 5% fall in the price of the commodity results in 10% rise in the demand for the commodity; it is a case of relatively elastic demand. The price elasticity of demand is greater than one.

4.     Relatively Inelastic demand:  when a big change in the price of a commodity is followed by a less than proportionate change in the quantity demanded, it is called relatively inelastic demand.  For instance a 10% fall in the price of a commodity results in 5% rise in the quantity demanded it is a case of relatively inelastic demand.  The price elasticity of demand is less than one.

5.     Unitary Elastic demand:  when price of a commodity and the quantity demanded change by the same proportion it is called unitary elastic demand.  For instance when Price of a commodity falls by 10% and the quantity demanded rises by 10% it is a case of unitary Elastic demand.  Therefore the price elasticity of demand is equal to 1.

Differences between Micro and Macro Economics

The following are the differences between Micro and Macro Economics.

1.      Scope:  Micro –Economics is concerned with study of Individual economic units such as a firm, a consumer etc.

Macro –Economics deals with large segments of the economy such as aggregate demand, general price level, national income etc.

2.      Method of study:  Micro- Economics studies the individual parts of the economy intensively (slicing Method).  Ex. Behaviour of a consumer.

Macro-Economics lumps up the individual units together into big lumps for the purpose of brief study.  Ex.  The study of national income.

3.     Different economic agents:  In micro-economics, each individual economic agent thinks about its own interest and welfare.  For example, Producers try to get maximum profit at minimum cost of production with the higher selling prices.

In Macro – economics, economic agents are different from the individual economic agents and their aim is to get maximum welfare of the country.  For example, the Government of India, one of the macro -economic decision maker in India has a goal to achieve economic welfare of India.

4.      Equilibrium Analysis:  Micro-Economics studies the partial equilibrium in the economy, such as consumer equilibrium, producer equilibrium etc.

Macro – economics studies the general equilibrium in the economy, such as equilibrium in the general price level etc.

5.     Domain:  Micro-economics comprises the theories such as theory of consumer’s behavior, the theory of production and cost, the theory of rent, wages, interest and Profits.

Macro-economics includes the theories like the theory of income, output and employment, consumption function, inflation etc.

6.     View:  Micro economics explains the different economic variables at micro level.  It is a detailed study giving Microscopic view.

Macro economics is a brief study of an economy as a whole.  So its study is defined as Birds eye view.

     In spite of various differences, both Micro and Macro economics are interdependent and complementary to each other.

                                                            

The law of Diminishing marginal Utility

The Law of diminishing marginal Utility is one of the most important Laws of Economics. It is derived from the Satiable Character of human Want, i.e., a single human want can be completely satisfied.  Gossen, a German Economist was the first to explain the Law of diminishing Utility. Prof. Alfred Marshall popularised it.

Statement of the law:  According to Prof. Alfred Marshall, “The additional benefit which a person derives from a given increase of his stocks of anything diminishes with the growth of the stock that he has.”  In other words, this law states that, when a person goes on consuming a commodity one after another without any time gap, the additional utility derived by him from successive unit goes on diminishing. For example, when a person is hungry and eats bread, the first slice of bread gives him more utility, the second slice gives him less utility and the third slice gives him still less utility. This is because when he consumes the first slice of bread, his want is satisfied to some extent, when he consumes the second one, a further part of his want is satisfied  and so on till his hunger is completely is satisfied.

The law of diminishing marginal utility can be explained with the help of a table:

Slices of bread consumed	Total Utility	Marginal Utility
1	50	50
2	90	40
3	120	30
4	140	20
5	150	10
6	150	0
7	140	-10

From the above table it is clear that when the consumer consumes the first slice of bread, the Marginal utility is 50 units, the second slice yields 40 units and the 3^rd,4^th, 5^th slices of bread give him 30, 20 and 10 units of Utility.  The 6^th slice gives him zero utility and 7^th slice results in negative utility of -10.

Assumptions:

1.    The law holds good when the different units of a particular commodity consumed by a person are identical in size, colour, quality taste etc.

2.  The successive units of a particular commodity consumed should be reasonably large.

3.     The successive units should be consumed without any time gap.

4.     The consumer should be normal.

      In the above diagram, OX axis measures the units consumed and OY axis measures the utility.  ac is the marginal utility curve which is downward sloping curve.  This curve shows that when a person goes on consuming a commodity without any time gap the marginal utility goes on diminishing marginal utility.

The Law of Demand

The Law of demand is one of the important laws of consumption.  It states the normal economic behavior of Man and expresses the inverse relationship between the price of the commodity and its quantity demanded.

The Law of demand states that “other things being equal, demand varies inversely with price”.  In other words, when the price of the commodity rises, the demand for the commodity falls and when price falls, the demand for the commodity rises.

The law of demand holds good only when all the factors which influence demand are held constant.  We assume the following conditions.

1.  The consumer’s income remains the same.

2.  Consumer’s tastes and preferences remain the same.

3.  The price of substitutes remains the same.

4.  There is no change in customs, traditions and fashion.

5.  There is no change in the supply as well as the quality of the commodity.

6.  Weather conditions remain the same.

7.  There is no quantitative and qualitative change in population.

8.  There is no change in Government policy.

The law of demand can be explained with the help of a market demand schedule.                

  MARKET DEMAND SCHEDULE

Price of the commodity X	Demand in kgs
5	100
4	200
3	300
2	400
1	500

   

  When the price of the commodity X is Rs 5, the quantity demanded is 100kgs, when price falls from Rs 5 to Rs 4, the quantity demanded expands from 100kgs to 200 kgs.  When price falls from Rs 4 to Rs 3, the quantity demanded expands from  200 kgs to 300kgs.  When price falls from Rs 3 to Rs 2, the quantity demanded expands to 400kgs and so on.
The law of demand can be explained with the help of a diagram.

In the above diagram, OX axis represents the quantity demanded and OY axis measures the price of the commodity X. When the price of commodity X is Rs 5,  100 kgs are demanded and when price falls to Rs 4, 200 kgs are demanded and so on, when we plot all the points and join them, we get DD a downward sloping demand curve which shows the inverse relationship between the price of a commodity and its quantity demanded.

The law of Variable Proportion

The law of variable proportion explains the relationship between proportion of fixed input and variable input on the one hand and output on the other during short period.  It is the modern Law of diminishing returns.  In the short period, if a firm wants to expand its production, it can do so by increasing its variable input keeping the fixed inputs constant.  As a result, the proportion between fixed and variable factors gets changed.  Such a situation is called the law of variable proportions.

Assumptions:

1.  Technology remains constant.

2.  One factor input is to be varied while all other factors remain constant.

3.  It is possible to change factor proportion.

4.  All the units of variable factors are equally efficient.

5.  Factors of production are not perfect substitutes.

The law of variable proportion can be understood with the help of the following example.  Let us suppose that a farmer uses a capital of Rs10, 000 on an acre of land and he uses labourers to cultivate the land.

Units of labour	Total product (in tonnes)	Average Product(in tonnes)	Marginal Product (in tones)
1	5	5	5
2	11	5.5	6
3	18	6	7
4	20	5	2
5	21	4.2	1
6	21	3.5	0
7	20	2.86	-1

There are three stages of Law of variable proportion:

1.  First stage or Increasing returns: When a firm expands its output by increasing the quantity of variable factor in proportion to fixed factor, it moves towards optimum combination of factors of production and at this stage, the marginal product increases and the total output increases at an increasing rate. 

Causes:  When more and more units of the variable factors are added to the constant quantity of the fixed factor it is more effectively and intensively used.

Output also increases due to effective and fuller utilization of the variable factor.

2.  Second Stage or Diminishing returns:  In the second stage, the total output continues to increase but at a diminishing rate and the marginal product diminishes. This stage continues till the total product reaches the maximum and the marginal product becomes zero.  The average product goes on diminishing indicating a decline in the efficiency of labour.

Causes:  The second stage occurs when the fixed factor becomes insufficient relative to the quantity of the variable factor.

The fixed indivisible factor is being worked too hard in a non-optimal proportion with variable factor.

3.  Third Stage or Negative Returns:  At this stage total product starts declining and marginal product becomes negative but Average product remains positive in spite of declining.

Causes:  The third stage operates when the number of variable factor becomes too excessive relative to the fixed factor.       

             ー    

In the above diagram, TP, from the point of origin to the point R increases at an increasing rate.  It is the first stage and MP curve rises in a part and then falls. The AP rises throughout and remains below MP.  From Point R onwards, during the stage II the total product increases at diminishing rate up to point T.  In the second stage both MP and AP are diminishing but are positive.  

In the third stage TP curve slopes downward from point T and the MP turns negative.  It moves below the X axis.