Showing posts with label Diminishing Marginal Utility. Show all posts
Showing posts with label Diminishing Marginal Utility. Show all posts

Law of Demand: Higher the price, the smaller the quantity demanded

Law of Demand


The law of demand is one of Alfred Marshall’s many contributions to economic theory. The demand varies inversely with price. The lower the price, the larger the quantity demanded. Similarly, the higher the price, the smaller the quantity demanded. This inverse relationship between price and quantity demanded is often called the Law of Demand. This law may be stated as – “Other things being equal, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, the larger the quantity demanded.”

This law is based on The Law of Diminishing Marginal Utility. According to this law, when a man consumes more and more of a commodity, the utility from latter units declines. Hence, at a given time in given market, people will not buy more of a commodity unless its price becomes lower. The lower price induces the persons already buying to buy more and other persons to start buying.

The law of demand is based on several assumptions:
  1. Taste and preference of the consumer remain constant.
  2. Prices of substitutes and complements remain constant.
  3. Consumer’s income is fixed and constant.
  4. The size of the population is unchanged.
  5. There is no change in distribution of income and wealth.
Demand Schedule
Price ($)
Quantity
12
10
8
6
4
2
2
3
5
7
10
14

A demand schedule shows the relationship between two variables, price and quantity. To be more precise, it indicates the quantity demanded by the consumer at each price. As shown in the demand schedule, when price per unit is $12, the quantity demanded is 2 units, when price falls to $10, $8, $6 and $4 per unit, the quantity demanded increases to 3, 5, 7 and 10 units respectively.

This law can also be illustrated with the help of a diagram known as demand curve. When the demand schedule is displayed geometrically, it is called demand curve. The demand curve also shows the price-quantity relation as the demand schedule.

Law of Demand

In figure, OX axis represents quantity demanded and OY axis represent price. DD is the demand curve. The demand curve has been constructed on the basis of the demand schedule. It shows that when price is $12 per unit, the quantity demanded is 2 units. When the price falls to $10, the quantity demanded increases to 3 units. When the price further falls to $8, the quantity demanded increases to 5 units and so on.

The slope of a demand curve is negative. It always slopes downwards from left to right. It implies that when the price of a commodity falls, the quantity demanded of that commodity increases.

Causes of Demand Curve Sloping Downwards

The demand curve slopes downwards to the right due to the following reasons:
  1. Law of Diminishing Marginal utility: According to this law, as a consumer consumes more and more of a commodity, the marginal utility of the commodity goes on declining. Hence, people demand more only when the price falls.
  2. Income effect: When the price of a commodity falls, there is an increase in the real income or purchasing power of people. Hence, they are able to buy more of that commodity.
  3. Substitution effect: When the price of a commodity falls, it becomes cheaper than other commodities. So people buy more of this goods or substitute this goods for other.
  4. New consumers: When the price of a good fall, new consumers who did not buy before due to inability to buy also buy. So, the demand for the commodity increases. As for example, the transistors made in Khasa of China has decreased considerably. As a result of this, many people have started to buy transistors.
  5. Put to less important uses: When a commodity becomes cheaper, people are inclined to put them to less important uses. Hence, the demand increases when the price of a commodity falls.

Exceptions to the Law of Demand

There are several limitations to the law of demand, which are as follows:
  1. Judged by price: This exception is associated with the name of T. Veblen and his doctrine of conspicuous consumption. If consumers measure the commodity entirely by its price, they will buy less of the commodity when the price falls, and more when the price rises. As for example, the demand for diamond for personal use or premium priced beer. The demand for diamond by rich falls when price decrease.
  2. Giffen Goods: The other exception is associated with the name of Robert Giffen. According to him, a rise in the price of bread causes to buy more bread, not less. Because, the wage earners subsist on the diet mainly on bread. When its price rises, they have to spend more money for a given quantity of bread. So, to maintain their intake of food, they buy more bread at higher price. According to Watson and Getz, these two exceptions to the law of demand are quite important.
  3. Price exception: To quote Watson and Getz again, the other exceptions to the law of demand are only apparent not real. When the consumers expect the price to fall even further, they do not buy more even if the price is lower. Likewise, when the consumer expect further rise in price, they buy more even if the price is higher.
  4. Articles sold under two brand name: The article may be sold under two brand names at the same time. The consumers buy more of the higher-priced brand than the lower-priced brand even though the articles are more or less identical. But the consumers think that the two brands are different. The two brands are taken as two different commodities.
  5. If shortage is feared: If people feel that the commodity is going to be scarce in future, they buy more of it even if the price is high. As for example, when people feel that cooking gas or kerosene is going to be of short supply in future, they buy more even if price is high.
  6. Out of fashion: If the commodity goes out of fashion, people do not buy more even if the price falls, as for example, people do not buy bell-bottom pants or pointed shoes these days even if their prices are lower relatively. Because, their use has gone out of fashion.
  7. Customs and tradition: The law of demand may not hold goods due to customs and traditions. As for example, the demand for clothes, goat increase during Dashain festival even if the prices are too much higher.
  8. Change in season: The law of demand may not hold good due to the change in season. The demand for umbrella does not rise even if price falls during winter season. Likewise, the demand for ice cream, Coca-Cola does not rise during winter even if price is substantially reduced.
  9. Necessaries of life: The necessaries of life are the things that the people cannot do without. Hence, even if the price of rice increases, the demand does not decrease.
  10. Change in income: If the income of people increase, they do not reduce demand for the commodities even if the price rise. On the contrary, if their income decreases, they reduce the demand even if the price of commodities falls.

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Utility and Risk Aversion in Investment Decision

The assumption of risk aversion is basic to many decision models in managerial economics. Because this assumption is too crucial, it is appropriate to examine attitudes toward risk and discuss why risk aversion might hold in general.

1. Possible risk attitudes

In this theory, three possible attitudes towards risk are presented as aversion to risk, indifference to risk, and preference for risk. Risk aversion characteristics individuals who seek to avoid or minimize risk. Risk neutrality characteristics decision makers focus on expected returns and disregard the dispersion returns (risk). Risk seeking characteristics decision makers prefer risk. Given a choice between more risky and less risky investments with identical expected monetary returns, a risk averter select the less risky investment and a risk seeker select the riskier investment. Faced with the same choice, the risk-neutral investor is indifferent between the two investment projects.

Given the importance of attitudes towards risk in economic decision making, it is important to ask what factors are involved in the determination of such attitudes. Managerial economics tends to presume that the majority of economic participants are risk averters, and it makes this presumption on the basis of the principle of diminishing marginal utility of money.

2. Relation between money and its utility

At the heart of risk aversion is the notion of diminishing marginal utility for money. If someone with no money receives $5000, it can satisfy his or her most immediate needs. If such a person then receives a second $5000, it will obviously be useful, but the second $5000 is not quite so necessary at the first $5000. Thus, the value or utility of the second or marginal $5000 is less than the utility of the first $5000 and so on. Consequently, diminishing marginal utility of money implies that the marginal utility of money income or wealth diminishes for additional increments of money.

Now, if this principle holds generally then it has an important implication for attitudes towards a 50/50 risk of gaining or losing a given monetary amount. This is that the extra benefit from making an equally likely gain is less than the loss of benefit from enduring an equality likely loss. For this reason, the diminishing marginal utility of money tends to make for risk aversion.

3. Adjusting the valuation model for risk

To the extent that diminishing marginal utility leads directly to risk aversion, then this risk aversion can be reflected in the basic valuation model used to determine the worth of a firm. If a managerial decision affects the firm’s risk level, the value of the firm is affected. Two primary methods are used to adjust the basic valuation model to account for decision making under conditions of uncertainty.

Under conditions of risk, the profits shown in the numerator of the valuation model as π equal the expected value of profits during each future period. This expected value is the best available estimate of the amount to be earned during any given period. However, since profits cannot be predicted with absolute precision, some variability is to be anticipated. If the firm must choose between two alternative methods of operation, one with high expected profits and high risk and another with smaller expected profits and lower risks, some technique must be available for making the alternative investments comparable. An appropriate ranking and selection of projects is possible only if each respective investment project can be adjusted for considerations of both time value of money and risk.

4. Certainty equivalent adjustment

The certainty equivalent method is an adjustment to the numerator of the basic valuation model to account for risk. Under the certainty equivalent approach, decision makers specify the certain sum that they are comparable to the expected value of a risky investment alternative. The certainty equivalent of an expected risk amount typically differs in monetary terms but not in terms of the amount of utility provided.

5. Risk-adjusted discounts rates

Another way to incorporate risk in managerial decision making is to adjust the discount rate of denominator of the basic valuation model equation (iii). Like certainty equivalent factors, risk-adjusted discount rates are based on the trade off between risk and return for individual investors.

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