MODULE II CONSUMER BEHAVIOUR AND ELASTICITY OF DEMAND
DEMAND
Demand refers to the willingness and ability of consumers to buy a particular good or service at a given price and time. It represents the amount of a product that consumers are willing to purchase at a given price and is typically depicted as a downward-sloping curve on a graph. The law of demand states that as the price of a product increases, the quantity demanded of that product decreases, ceteris paribus (assuming other factors remain constant).
Demand is influenced by a range of factors, including price, consumer preferences, income levels, the availability of substitutes, and market trends. As these factors change, the demand curve will shift accordingly. For example, if a consumer's income increases, they may be willing to buy more of a particular good, causing the demand curve to shift to the right. Conversely, if the price of a good increases, consumers may look for cheaper substitutes, causing the demand curve to shift to the left.
Understanding demand is important for businesses and policymakers alike. Businesses use demand analysis to set prices, make production decisions, and forecast sales, while policymakers may use it to design economic policies that aim to stimulate demand or regulate markets.
Determinants of demand
The determinants of demand refer to the factors that influence consumers' willingness and ability to purchase a particular good or service at a given price. These determinants include:
Price of the Product: The price of the product is the most significant determinant of demand. If the price of the product increases, the demand for it decreases, and vice versa.
Income: The level of consumer income also plays a vital role in determining demand. Generally, as income increases, the demand for normal goods also increases. In contrast, the demand for inferior goods decreases as income increases.
Prices of Related Goods: The demand for a particular product can also be influenced by the prices of substitute and complementary goods. If the price of a substitute good increases, the demand for the original product increases. In contrast, if the price of a complementary good increases, the demand for the original product decreases.
Consumer Tastes and Preferences: Consumer tastes and preferences also play a crucial role in determining demand. If a particular product is trendy and fashionable, the demand for it increases.
Advertising and Promotions: Advertising and promotions can influence the demand for a product. Effective advertising and promotional strategies can increase consumer awareness and encourage them to purchase the product.
Consumer Expectations: Consumers' expectations of future prices, income, and availability of the product can also affect demand. If consumers anticipate an increase in prices or a decrease in the product's availability, they may purchase more of it in the present, increasing the demand.
Demographics: The demographics of the target market, such as age, gender, and cultural background, can also affect demand for a product.
All these factors play a crucial role in determining the demand for a particular product or service. Understanding these determinants can help businesses make informed decisions about pricing, marketing, and other strategies to maximize their profits.
LAW OF DEMAND
The law of demand expresses a relationship between the quantity demanded and its price. It may be defined in Marshall’s words as “the amount demanded increases with a fall in price, and diminishes with a rise in price”. Thus it expresses an inverse relation between price and demand. The law refers to the direction in which quantity demanded changes with a change in price.
The law of demand is a fundamental principle in economics that states that, all else being equal, the quantity of a good or service that people are willing and able to buy decreases as its price increases, and vice versa. This means that as the price of a good or service increases, consumers will demand less of it, while as the price of a good or service decreases, consumers will demand more of it.
The law of demand is based on the idea that consumers have a limited budget and must make choices about how to allocate their spending. When the price of a good or service increases, it becomes relatively more expensive compared to other goods and services, which leads consumers to switch to alternatives or reduce their consumption of that good or service. Conversely, when the price of a good or service decreases, it becomes relatively less expensive compared to other goods and services, which leads consumers to increase their consumption of that good or service.
The law of demand is a key concept in understanding how markets work and how prices are determined. It is an important tool for businesses, policymakers, and economists to analyze consumer behavior“The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers, or in other words, the amount demanded increases with a fall in price and diminishes with a rise in price”. In simple words other things being equal, quantity demanded will be more at a lower price than at higher price. The law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a given period. The law indicates the inverse relation between the price of a commodity and its quantity demanded in the market.
Thus ‘Ceteris Paribus’;
(a) With a change in the price of the good, the consumer changes the quantity purchased by him. Normally, the consumer buys more of a good when its price falls and reduces the quantity when its price increases.
b) The quantity demanded must be related to the time interval over which it is purchased. For example, it is meaningless to say that a consumer buys 5 kg of sugar when its price is Rs. 12 per kg. The quantity bought must specify the time period, i.e., per day, per week, per month, or over some other period.
Factors determining demand for a commodity are: Price, Income of the consumer, Tastes & Preferences, Demographic factors, Seasonal factors etc. r and make predictions about market trends.
Assumptions of the Law of Demand:
The law of demand is based on several assumptions:
Ceteris Paribus: The law of demand assumes that all other factors that affect demand remain constant. This means that the price of the good or service is the only factor that changes, and all other factors, such as income, tastes and preferences, and the prices of related goods, are held constant.
Rationality of consumers: The law of demand assumes that consumers are rational and make decisions based on their own self-interest. They aim to maximize their utility or satisfaction with their limited resources.
Diminishing Marginal Utility: The law of demand is based on the assumption of diminishing marginal utility. This means that as consumers consume more units of a good or service, the additional satisfaction or utility they derive from each additional unit decreases.
Availability of substitutes: The law of demand assumes that consumers have access to substitutes for the good or service. If the price of a good or service increases, consumers can switch to a substitute, which reduces the demand for the original good or service.
Time frame: The law of demand is valid only in the short run. In the long run, consumers have more time to adjust to changes in prices and other factors that affect demand, so the law of demand may not hold true.
These assumptions form the basis of the law of demand and help us understand how consumers behave when faced with changes in prices of goods and services.
Three alternative ways of expressing Demand
Demand for a good by an individual or the market as a whole is conventionally expressed in three alternative forms, namely;
– a demand function
– a demand schedule
– a demand curve
Demand Function
A demand function of an individual buyer is an algebraic form of expressing his demand behavior. In it, the quantity demanded per period of time is expressed as a function of several variables. A demand function may be in a generalized form or a specific form. In the latter case, the function describes the exact manner in which quantity demanded is supposed to vary in response to a change in one or more independent variables.
General form of the demand function is Dx = f (Px , Y, T)
In a demand function Dx = f(Px , Y, T), the dependent variable is Dx , i.e. the demand for a commodity (a normal good) and Px (price), Y (income) and T (tastes and preferences of a consumer) are independent variables. In other
Demand Schedule
A demand schedule shows the quantity of a product or service that consumers are willing and able to buy at different price points. The demand schedule typically lists a series of prices in one column and the corresponding quantity of the good or service that consumers are willing and able to purchase at each of those prices in another column. It can be divided into individual demand, which is the quantity of a product or service that an individual consumer is willing and able to buy at different price points, and market demand, which is the sum of individual demand across all consumers in a market.
Here is an example of a demand schedule with both individual and market demand:
In this example, there are two individual consumers with different demand curves, and the market demand is the sum of their individual demands at each price point. At a price of $10, individual 1 is willing and able to buy 2 units and individual 2 is willing and able to buy 3 units, resulting in a market demand of 5 units. At a price of $8, individual 1 is willing and able to buy 3 units and individual 2 is willing and able to buy 4 units, resulting in a market demand of 7 units. The market demand curve is the horizontal sum of the individual demand curves at each price point.
Demand Curve
A demand curve is a graphical representation of the relationship between the price of a good or service and the quantity that consumers are willing to buy at that price. There are two types of demand curves: the individual demand curve and the market demand curve.
Individual Demand Curve: This curve shows the quantity of a good or service that an individual consumer is willing to purchase at different prices, holding all other factors constant. An individual demand curve is downward sloping, which means that as the price of the good or service increases, the quantity demanded decreases.
Market Demand Curve: The market demand curve is the horizontal summation of all individual demand curves in a market. It shows the quantity of a good or service that all consumers in a market are willing to purchase at different prices, holding all other factors constant. The market demand curve is also downward sloping, indicating that as the price of the good or service increases, the quantity demanded by all consumers in the market decreases.
To illustrate the difference between the individual and market demand curves, let's consider the example of a smartphone. Suppose that there are three consumers in the market for smartphones, and each consumer has an individual demand curve for smartphones, as shown below:
To find the market demand curve, we simply add up the quantities demanded by all three consumers at each price point, as shown below:
The market demand curve is also downward sloping, indicating that as the price of the smartphone increases, the quantity demanded by all three consumers in the market decreases.
SUPPLY
Supply represents how much the market can offer. The quantity supplied refers to the amount a good producer is willing to supply when receiving a certain price. The supply of a good or service refers to the quantities of that good or service that producers are prepared to offer for sale at a set of prices over a period of time.
DETERMINANTS OF SUPPLY
At any point in time, the total quantity supplied of a good or service in the market is influenced by a number of factors. Some of the important factors include the following:
Costs of the Factors of Production: The cost of factor inputs such as land, labor, capital, raw materials etc. is one of the determinant factors which influence the market supply of a product. For instance: if the price of labor goes up, then the supply of the product will decline due to higher labor cost.
Changes in Technology: The change in technology as a result of constant research and developments in terms of improved machinery, improved method of organization and management helps the business units or firms to reduce the cost of production. All this contributes significantly to increase the market supply at given prices.
Price of Related Goods (Substitutes): Prices of related commodities also affect the supply of the commodity (say X). If the price of a substitute good, Y increases, the supply for that good increases and the producer shifts the allocation of resources to Y from X.
Change in the Number of Firms in the Industry (Market): A change in the number of firms in the industry as a result of profitability also influences the market supply of a good. For example, an increase in the number of firms in the industry attracted by higher profit would increase the quantity supplied of goods over the range of prices.
Taxes and Subsidies: A change in government fiscal policy in terms of change in tax rate or amount of subsidy may influence the supply of a good in the market. A decrease/increase in the amount of tax/ subsidy on the good would allow firms to offer larger amounts of a good at a given range of prices.
Goal of a Business Firm: The goal of a business firm such as profit maximization, sales maximization or both is also responsible to influence the market supply of a good or service. In case the firm is interested in maximizing profit, the same may be attained by decreasing the market supply of a good under certain conditions whereas the goal of sales maximization will increase the supply.
Natural Factors: Natural Factors such as climatic changes, particularly in the case of agricultural products influence its supply.
Changes in Producer or Seller Expectations: The supply curve like the demand curve is drawn for a certain time period. If the expectations of the future prices change drastically in a market. For example, if prices of goods and services are expected to rise suddenly, the firm would hold current production from the market in anticipation of higher prices and thus influence supply of the goods.
LAW OF SUPPLY
The law of supply states that a firm will produce and offer to sell a greater quantity of a product or service as the price of that product or service rises, other things being equal. There is a direct relationship between price and quantity supplied. In this statement, change in price is the cause and change in supply is the effect. Thus, the price rise leads to supply rise and not otherwise. It may be noted that at higher prices, there is greater incentive to the producers or firms to produce and sell more. Other things include cost of production, change of technology, price of related goods (substitutes and complements), prices of inputs, level of competition and size of industry, government policy and non-economic factors. Thus ‘Ceteris Paribus’; (a) With an increase in the price of the good, the producer is willing to offer more goods in the market for sale. (b) The quantity supplied must be related to the specified time interval over which it is offered.
Three Alternative ways of expressing Supply
Supply of a good by an individual producer/firm or the market/industry as a whole is conventionally expressed in three alternative forms, namely;
– a supply function
– a supply schedule
– a supply curve
Supply Function
A supply function of an individual supplier is an algebraic form of expressing his behaviour with regard to what he offers in market at the prevailing prices. In it, the quantity supplied per period of time is expressed as a function of several variables.
General form of the supply function is Sx = f (Px , Cx , Tx)
Example of a supply function for good X is Sx = 200 + 15Px where, Sx denotes quantity supplied of good X, Px denotes the price of good X, Cx represents cost of production and Tx is technology of production.
Supply Schedule
A supply schedule is a tabular statement that shows different quantities or services that are offered by the firm or producer in the market for sale at different prices at a given time. It describes the relationship between quantities supplied of a good in response to its price per unit, while all non-price variables remain unchanged.
A supply schedule has two columns, namely
– price per unit of the good (Px)
– quantity supplied per period (Sx)
The supply schedule is a set of pairs of values of Px and Sx
There are two types of supply schedule, namely
– individual supply schedule
– market supply schedule
Individual supply schedule relates to the supply of a good or service by one firm at different prices, other things remain constant or equal. The market supply schedule, on the other hand, like market demand schedule is the sum of the amounts of goods supplied for sale by all the firms or producers in the market at different prices during a given time. Let us assume, there are two producers for a good.
In this case, the market supply schedule shows how much all three farmers are willing to supply at different prices, assuming that all other factors remain constant. The total market supply is the sum of the individual supplies of all producers in the market.
Supply Curve
The individual supply curve is a graphical representation of the information given in the individual supply schedule. The higher the price of the commodity or product, the greater will be the quantity of supply offered by the producer for sale and vice versa, other things remain constant.
It shows supply curve of producer A, where X-axis is quantity supplied and Y-axis shows prices. As the price increases from 10 to 60 the quantity supplied rises from 1000 to 6000, establishing a positive relation among the two. This implies that the supply curve is upward sloping
ELASTICITY OF DEMAND
Meaning of Elasticity
Perhaps one of the most useful concepts in demand and supply analysis, certainly from the point of view of a person interested in business strategy, is that of elasticity. Elasticity refers to the ratio of the relative change in a dependent to the relative change in an independent variable i.e. elasticity is the relative change in the dependent variable divided by the relative change in the independent variable. For example, the ratio of percentage change in quantity demanded to percentage change in some other factor like price or income.
Elasticity of Demand
Elasticity of demand forms part of demand analysis and it helps in measurement of the magnitude of relationship between demand and its determinant. Elasticity of demand is mainly of three types :
– Price Elasticity of Demand
– Cross Price Elasticity of Demand
– Income Elasticity of Demand
Price Elasticity of Demand (PED): This measures the responsiveness of quantity demanded to changes in the price of a good or service. If the PED is greater than one, it means that a small change in price leads to a proportionately larger change in quantity demanded, indicating that the good is price elastic. If the PED is less than one, it means that a change in price leads to a proportionately smaller change in quantity demanded, indicating that the good is price inelastic. Price elasticity of demand is a measure of how sensitive the quantity demanded of a good or service is to changes in its price. The degree of price elasticity of demand can be classified into five categories:
Perfectly Elastic Demand: Demand is said to be perfectly elastic when a small change in price leads to an infinite change in the quantity demanded. This occurs when consumers are extremely sensitive to changes in price and have many substitutes available. In this case, the price elasticity of demand is infinite (Elasticity = ∞).
Elastic Demand: Demand is said to be elastic when a small change in price leads to a proportional change in the quantity demanded. This occurs when consumers are moderately sensitive to changes in price and have some substitutes available. In this case, the price elasticity of demand is greater than 1 (Elasticity > 1).
Unit Elastic Demand: Demand is said to be unit elastic when a change in price leads to an equal percentage change in the quantity demanded. This occurs when consumers are neither highly sensitive or insensitive to changes in price. In this case, the price elasticity of demand is equal to 1 (Elasticity = 1).
Inelastic Demand: Demand is said to be inelastic when a change in price leads to a proportionally smaller change in the quantity demanded. This occurs when consumers are relatively insensitive to changes in price and have few substitutes available. In this case, the price elasticity of demand is less than 1 (Elasticity < 1).
Perfectly Inelastic Demand: Demand is said to be perfectly inelastic when a change in price has no effect on the quantity demanded. This occurs when consumers have no substitutes available and are willing to pay any price to obtain the good or service. In this case, the price elasticity of demand is zero (Elasticity = 0).
It shows various demand curves, where X-axis shows quantity demanded and Y-axis shows prices. Different types of price elasticity discussed above can be shown in a diagram.
DD1 – Perfectly Elastic Demand
DD2 – Elastic Demand
DD3 – Unitary Elastic Demand
DD4 – Inelastic Demand
DD5 – Perfectly Inelastic Demand
Income Elasticity of Demand (YED): This measures the responsiveness of quantity demanded to changes in consumer income. If the YED is greater than zero, it means that as income increases, the quantity demanded of the good also increases, indicating that the good is a normal good. If the YED is less than zero, it means that as income increases, the quantity demanded of the good decreases, indicating that the good is an inferior good.
Cross-Price Elasticity of Demand (XED): This measures the responsiveness of quantity demanded of one good to changes in the price of another good. If the XED is positive, it means that the two goods are substitutes, and an increase in the price of one good leads to an increase in the quantity demanded of the other good. If the XED is negative, it means that the two goods are complements, and an increase in the price of one good leads to a decrease in the quantity demanded of the other good.
Advertising Elasticity of Demand (AED): This measures the responsiveness of quantity demanded to changes in advertising expenditure. If the AED is greater than one, it means that a small increase in advertising expenditure leads to a proportionately larger increase in quantity demanded, indicating that the good is advertising elastic. If the AED is less than one, it means that a change in advertising expenditure leads to a proportionately smaller change in quantity demanded, indicating that the good is advertising inelastic.
FACTORS AFFECTING THE ELASTICITY OF DEMAND
The elasticity of demand refers to the degree to which the quantity demanded of a product or service changes in response to a change in its price. Here are some of the factors that can influence the elasticity of demand:
Availability of substitutes: If there are many substitutes available for a particular product or service, customers are more likely to switch to other options if the price of the original product increases, making demand more elastic.
Necessity of the product: Products that are deemed necessities, such as food, medicine, and housing, have inelastic demand because customers will continue to purchase them regardless of price changes.
Time: Over time, consumers may become more sensitive to price changes, causing demand to become more elastic. For example, if the price of gasoline increases, consumers may start to drive less or purchase more fuel-efficient vehicles.
Income level: Products that are considered luxury items may have more elastic demand because consumers are more likely to reduce their consumption of these items as their income decreases.
Brand loyalty: If consumers are loyal to a particular brand or product, they may be less likely to switch to alternatives if the price increases, making demand less elastic.
Market competition: If there is a high level of competition in a market, firms may be less able to raise prices without losing customers, making demand more elastic.
Product durability: Products that are durable or have a long lifespan, such as appliances or furniture, may have more elastic demand because consumers may delay their purchase until prices are lower.
Overall, the elasticity of demand depends on a variety of factors, including the availability of substitutes, the necessity of the product, time, income level, brand loyalty, market competition, and product durability.
IMPORTANCE OF ELASTICITY OF DEMAND
The concept of elasticity of demand is crucial in economics as it helps to determine the responsiveness of demand to changes in price or income. Elasticity of demand refers to the extent to which the quantity demanded of a product changes in response to a change in its price. The importance of elasticity of demand can be summarized as follows:
Pricing decisions: Firms need to know the degree of responsiveness of demand for their products to changes in prices to make effective pricing decisions. If the demand for a product is elastic, firms need to be careful when increasing prices, as this could lead to a significant reduction in demand and revenue. On the other hand, if the demand for a product is inelastic, firms can increase prices without worrying too much about a reduction in demand.
Revenue forecasting: Firms need to forecast their revenue accurately to make informed decisions about production and investment. The elasticity of demand helps to estimate the potential revenue impact of changes in price or income, allowing firms to make more informed decisions.
Taxation policies: Governments use the concept of elasticity of demand to design taxation policies that can generate revenue without significantly affecting consumer behavior. If a product has an inelastic demand, increasing taxes may not lead to a significant reduction in demand, generating revenue for the government.
Market competition: The elasticity of demand also affects the level of competition in a market. In a market where the demand for a product is elastic, firms need to compete on price, and any increase in price by one firm can lead to customers switching to another firm.
In summary, elasticity of demand is an essential concept in economics as it helps firms, governments, and individuals to make informed decisions regarding pricing, revenue forecasting, taxation policies, and market competition.
DEMAND FORECASTING
Meaning: Demand forecasting is the process of estimating the future demand for a product or service. It involves analyzing past trends and current market conditions to predict how much of a particular product or service customers will want to buy in the future.
This information is then used by businesses to plan their production, inventory, and sales strategies, as well as to make informed decisions about pricing and marketing. Accurate demand forecasting is crucial for businesses to optimize their operations, reduce costs, and maximize profits.
Need and Importance of Demand forecasting
Demand forecasting is important for several reasons:
Planning production: Accurate demand forecasting helps businesses plan their production schedules by ensuring they have the necessary resources to meet the demand for their products or services. This helps to minimize the risk of overproduction or underproduction, which can lead to inventory problems and lost sales.
Inventory management: Demand forecasting helps businesses manage their inventory levels by predicting future demand for their products or services. This allows them to avoid excess inventory that can lead to higher costs and the risk of obsolescence, as well as avoid stockouts that can result in lost sales.
Pricing strategy: Demand forecasting can help businesses set optimal prices for their products or services by considering the expected demand and competition in the market. This helps to maximize revenue and profits while remaining competitive.
Marketing strategy: Demand forecasting helps businesses plan their marketing strategies by identifying the best channels and tactics to reach their target audience based on the expected demand for their products or services.
Financial planning: Demand forecasting is important for financial planning, as it allows businesses to project their revenue and expenses based on expected sales. This helps them to make informed decisions about investments, budgets, and resource allocation.
Improved customer satisfaction: By accurately forecasting demand, businesses can ensure they have sufficient stock to meet customer demand, leading to fewer stockouts and better customer satisfaction.
Methods of demand forecasting
Demand forecasting methods can be broadly classified into two categories i.e. 1.Survey methods and 2 Statistical methods. Different methods of demand estimation have been presented below.
There are several methods of demand forecasting, including:
1. Survey Methods: Survey methods are generally used in the short run and estimating the demand for new products. In survey methods information about the future purchase plans of potential buyers are collected through direct interview of potential consumers or experts opinions. The different approaches under survey methods are
A. Consumers’ Survey method: Under this method, efforts are made to collect the relevant information directly from the consumers with regard to their future purchase plans. It is one of the oldest methods of demand forecasting. It is also called “Opinion surveys”.The intentions of the consumer are recorded by trained, reliable and experienced investigators, through personal interviews, e-mail or post surveys and telephonic interviews. A well structured questionnaire is designed with regards to preferences and willingness about particular products, reaction to price change or a change in other variables such as quality, sales promotion, advertisement, channel of distributions, packing, color etc. and consumers are asked to reveal their ‘future purchase plans with respect to specific items.
B. Collective Opinion Method: (Sale Force Opinion or Reaction Survey Method) Another variant of the survey method is Collective Opinion Method also known as “Sales – force polling” or “Opinion poll method” or “Reaction Survey Method”. In this method, instead of customers, salesmen, marketing manager, production manager, professional experts and the market consultants and others are asked to express their considered opinions about the volume of sales expected in the future. It is a very simple method and does not involve the use of any statistical techniques and takes advantage of collective wisdom of sale.
C. Experts Opinion Method or Delphi Method: It is a variant of opinion poll and survey method of demand forecasting. Under this method, outside experts are appointed. They are supplied with all kinds of information, statistical data and posed questions relating to an underlying forecasting problem. The management requests the experts to express their considered opinions and views about the expected future sales of the company. Then, an independent party seeks to form a consensus forecast by providing feedback to the various experts in a manner that prevents identification of individual positions.smen and managers.
2. Statistical Methods: In statistical methods historical or cross sectional data are used to forecast the future probable demand of a particular product by applying statistical models and mathematical equations. These methods are considered to be superior techniques of demand estimation. The important statistical methods used in demand estimation are
A. Trend Projection Method - In trend analysis, past data about the dependent and independent variables is used to project the sales in the coming years assuming that factors responsible for the past trends will continue to behave in similar manner in future also as they did in the past in determining the magnitude and trend of sales of a product. In this method a data set of past sales are taken at specified time, generally at equal intervals to depict the historical pattern under normal conditions.
B. Regression analysis: Regression analysis is a statistical method that uses historical data to predict future demand. It involves identifying the relationship between demand and other variables, such as price, advertising, and economic indicators. Regression analysis can be used to forecast both short-term and long-term demand.
C.Simulation: Simulation involves creating a model of the business environment and using it to test different scenarios. Simulation can be used to forecast demand under different market conditions, such as changes in price or competition.
The choice of method depends on the availability and reliability of data, the time horizon of the forecast, the complexity of the market environment, and the purpose of the forecast. A combination of methods may be used to improve the accuracy of the forecast.
CARDINAL UTILITY ANALYSIS
Cardinal utility analysis is an economic theory that measures utility (satisfaction or happiness) in numerical terms. According to this theory, individuals are able to express their preferences in terms of the satisfaction they derive from consuming goods and services. The satisfaction derived from consuming a good or service is called utility, and this utility can be measured in cardinal (numerical) terms.
Cardinal utility analysis assumes that individuals can rank their preferences for different goods and services in terms of a scale of utility. For example, an individual might rank the satisfaction derived from consuming a chocolate bar as 5 units of utility, and the satisfaction derived from consuming a bag of chips as 3 units of utility. This allows economists to measure the relative satisfaction derived from different goods and services, and to analyze how changes in prices or incomes affect consumer behavior.
INCOME CONSUMPTION CURVE
The income consumption curve, also known as the Keynesian consumption function, is a graphical representation of the relationship between income and consumption in an economy. It shows how the level of consumption changes in response to changes in income. In a typical income consumption curve, income is plotted on the horizontal axis (X-axis) and consumption is plotted on the vertical axis (Y-axis). The curve usually slopes upwards from left to right, indicating that as income increases, consumption also tends to increase. The income consumption curve is typically based on the assumption that consumption is a function of disposable income, which is the income that households have available for spending after taxes and transfers.
ENGEL CURVE
The Engel curve, also known as the Engel's law or the Engel's curve, is a graphical representation of the relationship between household income and expenditure on a particular good or service. It was developed by Ernst Engel, a 19th-century German statistician and economist, and it illustrates how changes in income affect consumer spending patterns.
The Engel curve typically shows the percentage of household income spent on a specific good or service on the vertical axis (Y-axis) and the level of household income on the horizontal axis (X-axis). It is usually drawn as a downward-sloping curve, indicating that as income increases, the proportion of income spent on the particular good or service decreases.
PRICE CONSUMPTION CURVE
The price consumption curve (PCC) is a graphical representation of the different combinations of two goods that a consumer can purchase at different prices while maintaining a constant level of satisfaction or utility. It shows the effect of changes in prices on the consumer's budget constraint and the resulting changes in consumption choices.
To derive the PCC, we start with a consumer's initial budget constraint, which represents all the combinations of two goods that a consumer can purchase with a given level of income and initial prices. The budget constraint is typically represented as a straight line on a graph, with one good on the horizontal axis and the other good on the vertical axis.
DERIVATION OF THE DEMAND CURVE
The demand curve is derived from the PCC by mapping the consumer's optimal consumption points onto a graph of quantity demanded versus price. The demand curve shows the quantity of a good or service that consumers are willing and able to purchase at different price levels, assuming all other factors, such as income and tastes, remain constant.
The quantity demanded is typically plotted on the horizontal axis, while the price is plotted on the vertical axis. By connecting the optimal consumption points from the PCC, we can obtain the consumer's demand curve, which shows the relationship between price and quantity demanded.
The demand curve typically slopes downwards, reflecting the law of demand, which states that as the price of a good or service decreases, the quantity demanded tends to increase, and vice versa, assuming all other factors remain constant. The shape and elasticity of the demand curve provide insights into the responsiveness of quantity demanded to changes in price, and are important tools for understanding consumer behavior and market dynamics in microeconomic analysis.
EFFECT OF PRICE CHANGE
The effect of a price change depends on whether it is an increase or a decrease, and how it impacts various economic agents such as consumers, producers, and the overall market. Here are some general effects of price changes:
Consumer behavior:
a) Price increase: A price increase can lead to a decrease in quantity demanded by consumers, assuming all other factors remain constant. Higher prices can reduce affordability, leading to lower demand as consumers may choose to buy less or switch to alternative goods or services. This is known as the substitution effect, where consumers may seek cheaper alternatives.
b) Price decrease: A price decrease can lead to an increase in quantity demanded by consumers, assuming all other factors remain constant. Lower prices can increase affordability, leading to higher demand as consumers may choose to buy more of the goods or service. This is known as the income effect, where consumers may have more purchasing power and can afford to buy more.
Producer behavior:
a) Price increase: A price increase can lead to higher revenue for producers, as they may be able to sell their goods or services at a higher price. It may also incentivize producers to increase production, which can result in higher profits.
b) Price decrease: A price decrease can lead to lower revenue for producers, as they may need to sell their goods or services at a lower price. It may also lead to a decrease in production, which can result in lower profits or even losses.
Market dynamics:
a) Price increase: A price increase can result in a decrease in overall demand in the market, as higher prices may reduce consumer purchasing power and demand. This can lead to a decrease in market sales and potentially lower economic activity.
b) Price decrease: A price decrease can result in an increase in overall demand in the market, as lower prices may increase consumer purchasing power and demand. This can lead to an increase in market sales and potentially higher economic activity.
CONSUMER SURPLUS
In economics, the total willingness to pay (TWTP) refers to the total amount of money that all consumers in a market are collectively willing to pay for a certain quantity of a good or service at a given price. It represents the sum of the individual willingness to pay all consumers in the market.
The willingness to pay (WTP) of a consumer is the maximum amount that the consumer is willing and able to pay for a good or service, based on their preferences, utility, and budget constraints. It represents the value or benefit that the consumer expects to derive from consuming the good or service.
The total amount paid (P), on the other hand, refers to the total revenue or total expenditure incurred by consumers in the market for a certain quantity of a good or service at a given price. It is the actual price paid by consumers to purchase the good or service, multiplied by the quantity consumed.
REVEALED PREFERENCE THEORY
Revealed preference theory was developed by economist Paul Samuelson in the 1930s and has since become an important concept in microeconomics, consumer theory, and welfare economics. The theory is based on the idea that consumer preferences can be inferred from observed market behavior, such as the goods and services that consumers purchase or the prices they are willing to pay, without the need for explicit preference surveys or assumptions about utility functions.
The key concept in revealed preference theory is the idea of a "revealed preference set" or a "choice set." A revealed preference set refers to the set of all possible choices that a consumer could have made in a given market, based on their budget constraint and the prices of goods and services. The choices that a consumer actually makes in the market reveal their preferences, as these choices reflect the consumer's decision on how to allocate their resources among different goods or services.
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