Textbook Notes (362,755)
Canada (158,052)
Economics (380)
ECO100Y5 (285)
Michael H O (131)

Theory of Demand.docx

22 Pages
Unlock Document

University of Toronto Mississauga
Michael H O

Home > Theory of Demand Theory of Demand There are three theories of demand or there are three theories of measuring demand: (a) Marginal utility analysis; (b) Indifference curve techniques; and (c) Revealed preference theory. Marginal Utility Analysis: Also known as ‘Utility analysis of demand’. Basic Assumptions: (i) Cardinal measurement of utility, (ii) Utilities are independent, (iii) Constant marginal utility of money, (iv) Introspection – drawing reference about a person from one’s own experience. (a) Law of Diminishing Marginal Utility: It refers to the additional benefit, which a persons derives from a given increase of his stock, diminishes with every increase in his stock. Characteristics: (i) The marginal utility diminishes which every increase in stock, (ii) The total utility is maximum when the marginal utility is zero, (iii) Each particular want is stable, (iv) Goods are imperfect substitutes and consumed in appropriate portions. Units Total Marginal of Utility Utility Stock (Units (Units of of Satisfaction) Satisfaction) 1 20 20 2 38 18 3 53 15 4 64 11 5 70 6 6 70 0 7 62 -8 8 46 -16 Assumptions/Limitations: (i) Consumption is continuous, (ii) The commodity is taken in suitable quantity, (iii) The commodity is taken at certain time interval, (iv) The greater the quantity of commodity is taken, the greater the utility, (v) Rational behaviour of consumer, (vi) Constant income of consumer, (vii) Change in other people’s stock, (viii) Possession of other related commodity, (ix) Trends in fashion not changed, (x) No change in the price of commodity, (xi) The marginal utility of rare collections does not diminished, (xii) The units of commodity taken are of same quality, (xiii) This law is not applied to the utility of money. Definition of Marginal Utility: It refers to the addition in total utility resulting from a one-unit change in the quantity consumed. The consumer stops purchasing at a point where the princes and the marginal utility are just equal. Above this point, the marginal utility will be negative. Marginal Utility of Money: The marginal utility of money increases with the increase in quantity of money. But the law of diminishing marginal utility also applies to money. As the amount of money increases it brings lesser and lesser pleasure to the recipient of money. Marginal Utility and Price: (i) The consume stops purchasing when the marginal utility and price are equal, (ii) The marginal utility indicates the prices. For example, it is the marginal utility not the total utility that determines prices; otherwise the price of water should have been high, and that of gold low. Marginal Utility and Supply: The greater the marginal utility, the lesser the supply, and vice versa. The marginal utility is equal to zero when the supply is super-abundant. Marginal Utility of Related Goods: (a) Imperfect Substitutes: The marginal utility increases with the decrease in quantity of substitute goods, and vice versa. (b) Complementary Goods: The marginal utility increases with the increase in the quantity of complementary goods, and vice versa. Importance of Law of Diminishing Marginal Utility: (a) Taxation: It provides the basis of the laws and practices of taxation. Since the marginal utility of money to a richer person is lower than poor person, therefore, higher tax rates are levied on him, and vice versa. (b) Price Determination: It refers to a decrease in the value of a commodity with an increase in its supply, and vice versa. (c) Household Expenditure: Larger the purchase, lower the marginal utility, and vice versa. (d) Downward Sloping Demand Curve: This law also provides the reason for downward sloping demand curve. (e) Value-in-Use and Value-in-Exchange: It also study the divergence between value-in-use and value-in-exchange. For example, air has a higher value-in-use (utility) but a very little value-in-exchange. (b) Law of Equi-Marginal Utility: The law of equi-marginal utility or the law of equilibrium utility is known by various names. It is also known as ‘law of substitution’, ‘law of maximum satisfaction’, ‘law of indifference’, ‘the proportionate rule’, and ‘Gossen’s second law’. The consumer compares the satisfaction which he obtains from the purchased commodity and the price he pays. If the utility of commodity is greater or at least equal to the loss of utility of money price, the consumer buys that commodity. As he buys more and more of that commodity, the utility of successive units begins to diminish. He stops further purchases at a point where the marginal utility of the commodity and the money he paid is just equal. Beyond this point the marginal utility is negative. And this can be stated as the point of equilibrium, where the consumer derives maximum satisfaction from a given commodity. If the consumer finds that a particular expenditure in one use is yielding less utility than that of other, he will try to transfer a part of his purchase from the previous commodity to the new one yielding higher utility. With two commodities, the consumer is in equilibrium at a point where the marginal utility of each commodity is in proportion to the price, and the ratio of the prices of all goods is equal to the ratio of their marginal utilities. It can be mathematically expressed as follows: or Units of Marginal Marginal Money Utility of Utility of (Rs.) Tea Cigar 1 10 12 2 8 10 3 6 8 4 4 6 5 2 3 Total Utility 30 39 Expenditure (Rs.) Rate of Marginal Utility On Tea On Cigar Marginal On Tea On Cigar Total Utility 5 0 N/A 30 0 30 4 1 2.3:4 28 12 40 3 2 1.1:1.5 24 22 46 2 3 0.6:0.7 18 30 48 1 4 0.3:0.2 10 36 46 0 5 N/A 0 39 39 Assumptions/Limitations: (a) This law becomes inoperative when the consumer demand is influenced by fashions and customs; (b) Consumers do not usually measure the utility of the purchased commodity; (c) This law becomes inoperative when the unit of expenditure is not divisible; (d) Again the law is inoperative when the people have no freedom of choice to choose between various alternatives. Practical Application of Law: (a) Consumption: Substitution of two commodities’ utilities in order to achieve maximum marginal utility; (b) Production: Substitution of two factors of production in order to maximise total profit; (c) Exchange: Substitution of any two things in order to achieve the desired things; (d) Price Determination: Substitution of less scarce good for the more scarce good in order to minimise the scarcity of more scarce goods. (e) Distribution: The use of each factor of production is pushed by the entrepreneur to the margin of profitableness till the marginal product in each case is equal; (f) Public Finance: Substitution of various public expenditures in order to maximise the benefit. Demand Curve: A fall in price has the following effects: (i) Income Effect: The real income of a consumer increases when the prices are decreased. Now the consumer can afford more purchases within the unchanged income. (ii) Substitution Effect: When the price of a product decreases, it tends to be substituted for other commodities. (iii) Cumulative Effect: A commodity with decreased price is put to more uses before; and therefore, it has a cumulative effect when the commodity is more purchased and used by the consumer. The Law of Diminishing Marginal Utility (LDMU) is the basis of the Law of Demand (LD). The consumer will buy more only if the price falls because more he buys the lower is the marginal utility. Demand is the function of price: D = f (P) In constructing the demand curve, we only consider the factor of price, and we ignore other factors, i.e., changes in fashion, wealth distribution, changes in real income, etc. Assumptions of Law of Demand: (a) The consumer’s tastes, habits, income, etc are remain unchanged; (b) Prices of substitutes and complementary goods are remain unchanged; (c) No expectations for further changes in commodity’s price; (d) No new substitute commodity has entered into the market. Relationship between LDMU and LD: (a) Law of diminishing marginal utility states that larger the quantity, less is the utility; (b) Law of demand states that larger the quantity, lower is the price, because the utility of the successive units is less; (c) This means that each addition to the quantity demanded, marginal utility of the consumer will be diminished; (d) Each additional unit of a good consumed within a given time period yields diminishing utility; Theory of Benham – Relationship between LDMU and LD: (a) According to Benham, when the price of a commodity falls a divergence is created between the marginal utility and price, and it must be rectified; (b) According to Benham, it must be rectified, so as to equalise the marginal utility from the last paisa that the consumer spends in different ways. And it can be done by purchasing more of the commodity, thus bringing the marginal utility to the level of price. Exceptional Demand Curve – Giffen Paradox: Sometimes the demand curve instead of sloping downward may tend to rise upwards from left to right. This situation is represented by more purchases at a rise in price. In other words, people buy more when the price rises. This situation is imaginary and was first observed by Sir Robert Giffen. His theory is commonly known as ‘Giffen Paradox’. Benham has mentioned four seasons/cases for this imaginary situation: (a) In case of war, hyper-inflation, draught, a serious shortage is feared and people may be panicked to buy more even if the prices are rising; (b) When the use of a commodity confers distinction, then the wealthy people will buy more when the price rises, to be included among the distinguished personages. Conversely, people tend to cut their purchases, if they believe the commodity to be inferior; (c) People may buy more, when the price rises, in sheer ignorance; (d) If the prices of necessary commodities go up, the consumer will ready just his expenditure, in order to maintain his previous quantity of purchases by reducing the purchases of other unnecessary commodities. Difference between Movement and Shift of Demand Curve: (i) Movement along demand curve refers to extension and contraction of demand. It means that the change in demand is the result of a change in price instead of a change in other factors. (ii) Shifting in demand curve refers to the increase or decrease of demand. It means that the change in demand is the result of a change in the factors other than price. Elasticity of Demand Kinds of Elasticities of Demand: (a) Price Elasticity, (b) Income Elasticity, (c) Cross Elasticity, and (d) Substitution Elasticity. (a) Price Elasticity: It is the price elasticity, which is commonly referred to as elasticity of demand. The law of demand indicates the direction of demand, however, it does not tell us the amount of quantity demand in response to a change in price. Price elasticity of demand, particularly, tells us the responsiveness of demand in reaction to the change in price of a commodity. It tells us the amount or the extent by which the demand will change in response to a change in the price. Degrees of Price Elasticity of Demand: (i) Perfectly Elastic Demand (e = ∞) (ii) Perfectly Inelastic Demand (e = 0) (iii) Unitary Elasticity of Demand (e = 1) (iv) Relatively Inelastic Demand (e < 1) (v) Relatively Elastic Demand (e > 1) Measurement of Price Elasticity: (i) Total Outlay Method (ii) Proportional Method (iii) Geometrical Method (i) Total Outlay Method: This method analyses the relationship between the price of commodity and total revenue earned by the seller. Under this method, the elasticity of demand can be expressed in three ways, i.e., unitary elasticity, greater than unity elasticity, and less than unity elasticity. a. Unitary Elasticity: Under the total outlay method, the unitary elasticity of demand is represented by the situation when, even though the price has changed the total amount spent or total revenue (from seller’s point of view) remains the same. This situation is represented by a ‘rectangular hyperbola’, where the elasticity is unity throughout the
More Less

Related notes for ECO100Y5

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.