Chapter 2: Demand Analysis

2.1. Concept of Demand

The theory of demand and supply enables us to understand the determination of prices and quantities in different markets. For example, why the prices of agricultural commodities such as tomatoes, apples, mangoes and cabbages increase and decrease at certain times of the year, why have the prices of computers, music systems and television sets been steadily declining over time. An understanding of the working of the price system provides us with the answers to some of these questions. The price system provides the basis for determining the prices of factors of production.

Demand refers to the quantity of a commodity that consumers are willing and able to purchase at any given price over a given period of time, holding other factors constant. It is important to realize that demand is not the same thing as want, need or desire. Only when want is supported by the ability and willingness to pay the price does it become an effective demand and have an influence on the market price. Hence demand in economics means effective demand. It is different from desire in that it has to be supported by the ability to purchase the product/service.

The price of a commodity is most important factor/determinant of demand. All factors affecting demand other than the price are referred to as conditions for demand. While analyzing the relationship between price and quantity of demand economists assume that all factors affecting demand remain constant. An individual demand for a given good can be presented in a form of a demand schedule. Demand schedule is a table showing quantity of a commodity that could be purchased at various prices. The Table 2.1 shows an individual’s demand for commodity X.

From the table, 65 units of commodity X will be demanded per week if the price is Kshs 6 per unit.

A demand schedule can be represented in the form of a graph known as a demand curve. Figure 2.1 shows the demand curve for commodity X. The curve shows graphically the relationship between quantity demanded and the price of the commodity. A demand curve has a negative slope. It slopes downwards from left to right showing that as the price of a commodity falls demand increases. The inverse relationship between the price of a commodity and the quantity demanded is what is referred as the law of demand.

The law of demand states that, “ceteris paribus (other factors remaining constant), the lower the price of a commodity the greater the quantity demanded by the individual and vice versa”.

Exceptions to the Law of Demand

There are some demand curves that slopes upwards from left to right showing that as the prices of a product rise more quantities of the product is demanded and vice versa. This type of demand curve is known as regressive, exceptional or abnormal demand curve and occurs in the following situations:

• When there is fear of a more drastic price changes in the future. This will cause consumers to increase their quantity demanded to avoid paying a higher price in the future. This situation is often found in the stock exchange where there is often an increase in the demand of shares of a company if its shares are expected to increase.
• Giffen goods: This refers to basic foodstuffs that constitute a high proportion of the budget of low income families. When the price of a giffen good rises, the proportion of the total income of individuals who consumes these giffen goods rises and since such consumers are worse off in real terms, they can no longer afford to consume other more expensive commodities like meat and fruits. To make up for the goods they can no longer afford to buy, they are more likely to purchase more of basic foodstuffs; conversely when the price of basic foodstuffs falls, they become better-off in real terms and are likely to buy more or relatively more expensive foodstuffs and less basic foodstuffs; i.e. ugali and meat.
• Goods of ostentation (Veblen goods). These are commodities whose prices fall in the upper price ranges and that have a snob appeal. The wealthy are usually concerned about status. Believing that only goods at high prices are worth buying and worth the effect of distinguishing them from other consumers. In the case of such commodities, a firm increasing its prices may find that the sales of its product increase and at lower prices less of the commodity maybe bought as the commodity is rejected as being substandard. Consumers often in making comparisons between similar products with different prices opt for relatively more expensive product, believing it to be better. As prices increase demand increases this is referred to as snob effect. Examples of goods of ostentation are expensive perfume, jewelry, cars, clothes, etc. The demand curve will be positively slopping as indicated in Figure 2.2.

1. Inferior goods: these are goods assumed to be of low quality compared to others available that can be used to satisfy same want. An increase in price of an inferior good may be taken to mean an improvement in quality. Demand for such commodities will hence tend to increase with increase in prices.
2. Expectation of future shortages: consumers buy more of a commodity whose prices are rising due to the expectation of a future shortage of the commodity.
3. Necessities: they are necessary for life. Demand will not change even if prices go up.
4. Habitual goods and services: a consumer will consume certain goods and services at same quantity at any price because these goods have become habitual and one can’t do without them e.g. addictives i.e. drugs.

The Determinants of Demand

The demand of the product can be considered from the standpoint of either individual demand or market demand. Demand for any commodity can be considered from two points of view:

a) Individual Factors Affecting Demand is the amount the individual is willing and able to buy at a given price and over a given period of time. Factors affecting individual demand are:

1) The price of the product

When deciding whether or not to buy a particular product, an individual will compare the price of the product and the amount of utility or satisfaction expected to be received from the product. If the price is considered worth the anticipated utility the individual will buy the product and if not will not buy. A decrease in the price of a product will probably increase individual’s demand for it since the amount of utility obtained is likely to be worth the lower price. Conversely a rise in the price of a product will probably result in a fall in demand, as the amount of utility received is less likely to be worth the higher price to be paid. An example of this phenomenon is the hotel industry in Kenya. There is usually an increase in domestic tourism during the low season when many Kenyans consider the lower hotel prices to be worth the level of satisfaction they are receiving. During the high season when the hotel prices are high, many do not consider the satisfaction they are receiving to be worth. If the amount a consumer is willing and able to purchase due to change in the price, a change in the quantity demanded is said to take place. If on the other hand the amount the consumer is willing and able to purchase changes because of a change in the price of a given commodity leads to a change in the quantity demanded will be undertaken later in utility analysis and indifference curve analysis

2) The prices of related goods

The demand for all goods is interrelated in that they are competing for consumer’s limited income. Two peculiar interrelationships can be:

Substitutes

Goods such as tea and coffee butter and margarine, beef and mutton, a bus ride and a matatu ride, a mango and an orange, CDs and cassettes. Two goods, X and Y are said to be substitutes if arise in the price of one commodity, say Y, leads to a rise in the demand of the other commodity X. If the price of tea increases consumers will find coffee relatively cheaper to tea as; a result, the demand for coffee increases. Substitutes are commodities that can be used in place of other goods. This phenomenon is illustrated in Figure 2.3. The graph shows the relationship between the prices of tea over the quantity for coffee. If the price of tea increases from P1 to P2 the quantity demanded of coffee rises from Q1 to Q2.

Complements

Complement goods such as shoe and polish, pen and ink cars and petrol, computers and software, bread and margarine, hamburgers and chips, tapes and tape recorders. Demand for some commodities can also be affected by changes in the prices of the complementary if a rise in the price of one of the goods, say A leads to the fall in the demand of another food, say B. Complimentary goods are usually jointly demanded in the sense that the use of one requires or is enhanced by the use of the other. Figure 2.4 illustrates the relationship between complementary goods graphically. For example if the price of cars is lowered demand for petrol increases because more cars will be bought/demanded. The curve shows the relationship between the price of a car and quantity demanded for petrol. If the price of cars falls from P2 to P1 the quantity demanded for petrol increases from Q1 to Q2

Figure 2.4 Demand Curve for Complementary Goods

3) Disposable Income

An individual’s level of income has an important effect on the level of demand for most products. If income increases demand for the better-quality goods and services increases. This relationship however, depends on the type of goods and level of consumers‟ income. The three types of are goods are:

• Normal goods: these are goods whose demand increases as income increases. The demand for normal goods increases continuously with increase in income. It tends to become gently as people reach the desired level of satisfaction.
• Inferior goods: They refer to goods for consumers with low income levels such that as income increases its demand falls. At low level of income, these individuals will tend to consume large amount of these goods but as income increases they buy other goods which they consider superior thus demanding less of the inferior goods. At very low level of income an inferior good behaves like a normal good only to behave inferior as income increases
• Necessities: these are goods which consumers cannot do without such as salt, match boxes among others. Their income demand curve tends to remain constant other than at the lowest levels of income as indicated in Figure 2.5.

4) Consumer tastes, preferences and fashion

Personal tastes play an important role in governing the consumer’s demand for certain goods. For example, preferring to consume imported commodities despite them being extremely expensive. Prevailing fashions are an important determinant of tastes. The demand for clothing for example, particularly is susceptible to changes in fashion.

5) Level of advertising

The level of advertising is also an important determinant of demand. In highly competitive markets, a successful advertising campaign will increase the demand of a particular product while at the same time decreasing the demand for competing products. Increase in advertising will increase demand in the following ways:

• It helps inform about the product of a firm
• Can introduce new products to the market.
• Induce individuals to frequently use the product/service

The factors affecting advertising policies include:

• Cost of advertising
• Mode of advertising
• Impact of advertising on the demand of the product
• The target group (old, young)
• The number of competitors and quality of their products
• The market share of the fi rm and the degree of competition
• Future expectations in price changes
• Government policies and taxes
• Appropriate time to make advertisements
• Cultural background
• Languag3

6) The availability of credit consumers

This factor especially affects the demand for durable consumer goods which are often purchased on credit. For example a decrease unavailability of credit or the introduction of more stringent credit terms is likely to lead to a reduction in the demand of some durable consumer goods.

7) The government policy

The government may influence the demand of a given commodity through legislation. For example making it mandatory for everyone to wear seatbelts. The consumers inevitably get to purchase more seatbelts as a result. Subsidies and taxation policies affect prices in opposite directions. When the government grants subsidies prices of goods falls leading to increase in demand and vice versa. On the other hand, taxation increases the price of the product, leading to reduced demand. Price controls and legislations are also government methodologies that will affect demand

8) Weather conditions and climate change

The demand for various goods varies depending on weather. For instance there is high demand for woolen clothes during rainy reasons.

b) Market Factors Affecting Demand

Aggregate or market demand refers to the horizontal demand sum of the demands for individual consumers. It refers to quantity demanded in the market at each price by individual consumers. For this reason all the factors affecting individual demand will affect market demand. The market demand for a commodity can be derived graphically as in Figure 2.6.

Where P1, P2 and P3 are individual prices Q1, Q2 and Q3 are individual quantities demanded. Pmkt is the market price Qmkt is market quantity demanded. Other factors affecting market demand include:

• Change in population: market demand is influenced by the size of the population, the composition of the population in terms of age, sex as well as geographical distributions.
• Distribution of income more even distribution of income may increase demand for normal goods while at the same time it may lower the demand for luxuries.

Movement Along and Shift in Demand Curve

Demand is a multi-variant function in the sense that it is influenced by so many factors such as the price of the commodity, the price of other related commodities, consumer incomes etc. The price of the commodity is the most important determinant of demand and its relationship with the quantity demanded give rise to a demand curve. Movement along demand curve is demonstrated by a change in the price of a good as shown in Figure 2.7 by movement from one point to another on the same demand curve.

A change in price of a good from P1 to P2 causes a movement from point A to B along the demand curve. This movement along demand curve shows a change in quantity demanded which is an increase or a fall in the quantity demanded. A shift in the demand curve is caused as a result of a change in any factor affecting demand other than price such as changes in consumer income tastes and preferences.

For this reason all other factors affecting demand other than price ofthe product are also referred to as shifting factors as illustrated in Figure 2.8. Any change in the shifting factors will cause changes in demand (an increase or a fall in demand). A shift to the right (dd to d1d1) shows an increase in demand while a shift from (dd to d2d2) shows a decrease in demand.

Terms Used in Demand

• Joint demand it is the demand whereby two commodities are always demanded together. One good cannot be demanded in the absence of the other such as car and petrol.
• Competitive/rival goods it is the demand for goods which are substitutes such tea and coffee.
• Derived demand where goods are demanded in order to provide goods such as cotton is required to produce cotton wool.
• Composite demand (several uses) where some goods are used for different purposes such as steel for cars machine etc.

Elasticity of Demand

Elasticity can be defined as the ratio of the relative change of a dependent variable to changes in another independent variable. Elasticity can be analyzed in terms of demand and supply. The elasticity of demand of a commodity can be defined as a measure of responsiveness of quantity demanded of a good to changes in factors affecting demand such as own price, income or prices of other related goods. There are three types of elasticity; price elasticity of demand, cross elasticity of demand and income elasticity of demand.

• Price elasticity of demand: This is the measure of responsiveness of the quantity demanded of a commodity to changes in its own price. It is also referred to as own price elasticity. It abbreviated as PED/ED. It is calculated as follows:

If changes in prices cause more than proportionate change in quantity demanded it is said to be price elastic, in this case ED >1. If changes in the price causes less than proportionate change in quantity demanded, then demand is said to be price inelastic this is represented by ED < 1. If changes in price causes proportionate change in quantity demanded then, demand is said to be unit elastic or unitary elastic where ED = 1

To illustrate price elasticity consider the Table 2.3 which shows demand schedule of commodity X.

This price is elastic because 3 > 1. The price elasticity of demand is classified into two:

• Point elasticity
• Arc elasticity

Point elasticity of demand

The point elasticity of demand measures elasticity at a particular point along the demand curve. It is calculated using the formulae:

Example: Calculate the point elasticity of demand given that Qd = 4P +2P³ – 3; Where P =1

Arc Elasticity of demand

This measures the elasticity of demand between two points on the demand curve. Arc elasticity is the coefficient of the price elasticity between two points on the demand curve. It is therefore an estimate of the elasticity along a range of the demand curve. This estimate improves as the arc becomes small and approaches a point in the limit. Arc elasticity can calculated for both linear and non-linear demand curves using the following formula: It is illustrated as in Figure 2.26.

Types of Elasticity

There are five types of elasticity of demand.

• Perfectly elastic demand. Demand is said to be perfectly elastic when the consumers are willing to buy an amount of a commodity at a given price, but non at a slightly higher price. In this case elasticity of demand is equally to infinity. The will be a horizontal straight line as illustrated in Figure 2.28. This is a case of a commodity in a perfectly competitive market. Where an increase in price may lead to a loss of all customers.

• Elastic demand. Demand is said to be price elastic when a change in price causes more than proportionate change in quantity demanded. In this case the value of elasticity of demand is greater than 1 and the demand curve will be gently sloped as indicated in Figure 2.29. This implies that if prices increase from P1 to P2 the quantity demanded falls in greater proportion from Q1 to Q2 and vice versa. This is a case of luxury commodity which consumes can do without or a case of a substitute.

• Unity elastic demand. Demand is said to unit elastic if changes in price cause proportionate change in quantity demanded. If price increase quantity falls in the same proportion and vice versa. ED = 1and the demand curve will be rectangular hyperbola as illustrated in Figure 2.30. This is a case of a good that lies between a luxury and necessity such as soap opera film or movie

• Inelastic demand. Demand is said to be price inelastic if changes in price causes less than proportionate change in quantity demanded. If prices increases the quantity falls in less proportion and if the prices falls the quantity demanded increases in less proportion ED < 1 as illustrated in Figure 2.31. This is a case of a good which is a necessity. These are goods which consumers cannot do without but need not be consumed in fixed amount like an absolute necessity such a staple food like ugali and milk. It also applies in the case of habit forming goods like beer and cigarettes

• Perfectly inelastic demand. Demand is said to be perfectly price inelastic if changes in price has no effect on the quantity demand(ED= 0). In this case the demand curve will be vertical straight as illustrated in Figure 2.32. This is a case of a good which is an absolute necessity. A good that consumes cannot do without and have to consume in fixed amounts such as salt.

Factors Affecting the Price Elasticity of Demand

• Substitutability

Substitutability refers to the ability or degree to which a product can be substituted with another good. If a substitute is available in the relevant price range, quantity demanded will be elastic. The demand for a particular brand of cigarettes maybe considered being elastic because if there is existence of other brands that are close substitutes. However, the total demand for cigarettes may be inelastic because there are no close substitutes for cigarette. It can hence be said that the greater the number of substitutes for a given commodity, the greater will be its price elasticity of demand.

• The proportion of a consumer’s income spent on the commodity

If this proportion is very small as in the case of match boxes, the quantity demanded will tend to be inelastic. On the other hand if this proportion is relatively large as for example in the case of meat, demand will tend to be elastic. This implies that the greater the proportion of income which the price of the product represents, the greater price elasticity of demand will end to be.

• Habit Forming Products

The price elasticity of demand can also be affected by the extent to which the product is habit forming. Habit forming products like cigarettes or alcohol have a low price elasticity of demand. In the case of in addiction to, say drugs, the price elasticity of demand is likely to be even lower.

• The number of uses of a commodity

The greater the number of uses of the commodity, the greater the price of elasticity. The elasticity of aluminum for example is likely to be much greater than that of butter because butter is mainly used as food while aluminum has hundreds of uses such as electrical wiring and appliances.

• The length of adjustments

The longer the period allowed for adjustment in the quantity demanded as a commodity the greater its price elasticity is likely to be. This is because it usually takes some time for new prices to be known and for consumers to make the actual switch. Consumers adjust buying habits slowly.

• The level of prices

If the ruling price is at the upper end of the demand curve, quantity demanded is likely to be more elastic than if it was towards the lower end. This is always true for a negatively sloped straight line demand curve.

• Necessities versus luxuries

Demand for luxury is likely to be price elastic while the demand for necessities is generally price inelastic. However, this depends with availability of close substitutes.

• Width/size of the market

The wide definition of the market of good, the lower is the price elasticity of demand. Thus for wide markets demand will tend to be price inelastic while for a small market demand will tend to be price elastic.

• Time Range: Short Run v Long Run

Time demand for most goods and services tend to be more elastic in the long run as compared to the short run period. This is because consumers will take some time to respond to price changes. For instance, if the price of petrol falls relative to diesel, it will take long for motorists to respond because they are locked in existing investment in diesel engines.

• Durability of the commodity

Durable goods have low elasticity of demand or they are price inelastic while perishable goods are price elastic.

Importance of price elasticity of demand/economic application of the concept of elasticity

• The consumer needs knowledge of elasticity when spending income where more income is spent on goods whose elasticity of demand is inelastic and vice versa.
• The government imposes taxes with inelastic demand and vice versa. Devaluation when a country devalues or lowers the value of its currency. The currency is made cheaper relative to other currencies. This makes a country’s exports cheaper for foreigners. Its import expensive for the residents. For a country to benefit by increasing exports, the elasticity of demand must be high.
• Business/producers: They use elasticity of demand on deciding on whether to charge high or lower prices or even deciding on commodities to bring to the market especially those which are price inelastic.

Income Elasticity of demand

It is the measure of responsiveness of demand due to change in income.

YED = ΔQ ∕Q/ ΔP∕Y

Where income elasticity is positive this is a normal good. Where income elasticity is negative this is an inferior good. When the demand of a good does not change with increase in income then income elasticity is zero. In wealthy countries for instance basic clothes will tend to have low income elasticity of demand while foreign will have high elasticity of demand as income increases. In poor countries basic commodities will have high income elasticity compared to manufactured expensive goods.

Importance of Income Elasticity of Demand

• Business firms: if demand of a commodity is elastic to income, it’s possible to increase revenue by reducing prices. Businesses use specific information to know which price to increase to eliminate shortages or which price to reduce to eliminate surpluses.
• Government uses elasticity to determine the yield of indirect taxes. Inelastic commodities are highly taxed. However, if demand of a commodity is elastic an increase in tax will hinder production
• Income elasticity is relevant for a country considering devaluation as a means of rectifying balance of payment disequilibrium. Devaluation decreases imports and increases exports. However, this will depend on demand of import and export elasticities.
• It helps to explain price instabilities in the agricultural sector
• Monopolists apply price discrimination by understanding the demand elasticities. High price is charged to those markets with lower income elasticity

Factors Affecting Income Elasticity of Demand

• Nature of the need that the commodity covers. For certain goods and services the percentage of income spent declines as income increases such as food.
• The initial level of income of a country (level of development) TV sets, refrigerators, motors vehicles are considered as luxuries in underdeveloped countries while they are considered as necessities in countries with high per capita income.
• Time period. The demand for most goods and services will tend to be income elastic in the long run as compared to short run period. This is because the consumption pattern adjusts with time and also with change in income.

Cross Elasticity of Demand

It is the measure of responsiveness of quantity demanded of a good due to changes in the price of another related good. It is abbreviated as EXY where X and Y are to goods. It is calculated as follows:

EXY = Proportionate change in quantity demanded of a good X/Proportionate change in quantity demanded of a good Y

ΔQx .Py ΔPy Qx

The sign of cross elasticity of demand is positive if the good X and Y are substitutes and negative if X and Y are complementary. The higher the absolute value of cross elasticity of demand the stronger the degree of substitutability or complementarity. The main determinant of cross elasticity is the nature of the commodity relative to their uses. If two goods can certify equally the same need the cross elasticity will be high and vice versa.

Importance of Cross Elasticity of Demand

• Protection of local industries. If the government imposes a tariff on a good with the intention of protecting a local industry then the local product and the imported product must be close substitutes for the government to achieve its objectives
• If a firm is in a competitive market, there a high positive elasticity of demand between its products and those of competitors. For such a firm, it will not be in its interests to increase the price of its product as this may result to more than proportionate reduction in its sales. However, it might consider lowering the prices of its products in the hope of attracting customers from other fi rms.
• For product with high degree of complementarity, a fall in price of one of the goods due to increase in supply will benefit the producers of a compliment product due to an increase in sales. E.g. if there is a fall in prices of vehicles, due to an increase in supply the suppliers of fuel experience an increase in sales because more cars will be bought.