MID-TERM EXAM TERM PAPER SPRING 2020

(Session 2019-2023)

COURSE TITLE & CODE

Microeconomics (ECON-5113)

SUBMITTED BY
Muhammad Salman

ROLL NO
BBAF19M019

SUBMITTED TO
Muhammad Waqas

PROGRAM
BBA (4 year) REGULAR

NOON BUSINESS SCHOOL

UNIVERSITY OF SARGODHA
 Law of Demand--------Case Study
Demand:
Demand is an economic principle referring to a consumer’s desire to purchase
goods and services to pay a price for a specific good or service. Holding all other factors
constant, an increase in the price of a good or service will decrease the quantity
demanded and vice versa.1
Demand of commodity refers to the quantity of a commodity which a consumer is
willing to buy at a given price, and time.2
Types of Demand:
Demand is generally classified on the basis of various factors, such as nature of a
product, usage of a product, number of consumers of a product and suppliers of a
product. The different types of demand are discussed as follows:
i. Individual and Market Demand
The individual demand refers to the demand for goods and services by the single
consumer, whereas the market demand is the demand for a product by all the
consumers who buy the product. Thus, the market demand is the total of the
individual demand.

ii. Total Market Demand and Market Segment Demand

The total market demand refers to the total demand for a product by all the
consumers in the market who purchase a specific product. Further, this aggregate
demand can be sub-divided into the classes on the basis of geo-graphical areas,
price sensitivity, costumer size, age, sex etc. are called as the market segment
demand.

iii. Derived Demand and Direct Demand

When the demand for a product is associated with the demand for another product
is called as the derived demand. Such as the demand for cotton yarn is derived
from the demand for cotton cloth. Whereas, when demand for the product is
independent of the demand for another product is called as the direct demand.
Such as, in the above example the demand for a cotton cloth is direct demand.

iv. Industry Demand and Company Demand

The industry demand refers to the total aggregate demand for the products of a
particular industry, such as demand for cement in the construction industry. While
the company demand is a demand for the product which is particular to the
company and is a part of that industry. Such as demand for tire manufactured by

1
https://www.investopedia.com/terms/d/demand.asp
2
https://www.slideshare.net/rameshkumar730/demand-61156555
 the Goodyear. Thus, the company demand can be expressed as the percentage of
the industry demand.3

v. Short-Run Demand and Long Demand

The short term demand is more elastic which means that the changes in price or
income are reflected immediately on the quantity demanded. Whereas, the long
run demand is inelastic, which shows that demand for commodity exists as a
result of adjustments following changes in pricing, promotional strategies,
consumption patterns, etc.4

vi. Price Demand

The demand is often studied in parlance to price and is therefore called as price
demand. The price demand means the amount of commodity a person is willing to
purchase at a given price. While studying the demand, we often assume that the
other factors such as the income of the consumer, their tastes and preferences, the
prices of other related goods remain unchanged.

vii. Income Demand

The income demand refers to the willingness of an individual to buy a certain
quantity at a given income level. Here, the price of the product, customer’s tastes
and preferences and the price of the related goods are expected to remain
unchanged. There is a positive relationship between the income and demand.

viii. Cross Demand

It is one of the important type of demand where the demand for a commodity
depends not on its own price, but on the price of other relate products is called as
the cross demand. Such as with the increase in the price of coffee the
consumption of tea increases, since tea and coffee are substitutes to each other.
Also, when the price of cars increase the demand for petrol decrease, as the car
and petrol are complimentary to each other.

Law of Demand:
The law of demand expresses the relationship between the quantity demanded and
its price. Marshall said that: “The amount demanded increases with a fall in price, and
decreases with a rise in price.”5
In law of demand the other factors being constants, the price and quantity of a
good are mutually exclusive. If the price of any good increase, the demand for it will

3
https://businessjargons.com/types-of-demand.html
4
https://businessjargons.com/types-of-demand.html
5
https://www.economicsdiscussion.net/law-of-demand/the-law-of-demand-with-diagram/21903
decrease. In the words of Benham: “Usually a larger quantity of commodity will
demanded at lower price that a higher price.”6

For Example: You desire to have a car, but you do not have enough money to buy
it. Then this desire will remain just a wishful thinking, it will not be called demand. Even
if you have that much money, you won’t spend it on the car, the demand doesn’t come
up. Desire becomes demand only when you are ready to spend money to buy a car.
Assumptions of Law of Demand:
1. Tastes and preferences of the consumers remain constant.
2. There is no change in the income of consumers.
3. Prices of the related goods do not change.
4. Consumers do not expect any change in the price of commodity in near future.
5. The commodity is a normal good and has no status value.

Limitations of Law of Demand:

Law of Demand indicates the inverse relationship between price and quantity
demanded of a commodity. It is generally valid in most of the situations. But there are
some situations under which there may be direct relationship between price and quantity
demanded of a commodity. These exceptions are known as exceptions to the law of
demand.7

6
https://sites.google.com/site/economicsbasics/law-of-demand
7
https://www.coursehero.com/file/p9fb6f/Limitations-of-Demand-Law-Law-of-Demand-indicates-the-
inverse-relationship/
  Consumer ignorance
Consumer ignorance induces them to buy or purchase more in the expensive
markets. Sometimes they think that more expensive goods are better in quality.
Thus with the increase in price, demand increases.

 Necessary Goods
There are some commodities which are not necessary but have become necessities
because of their constant use and fashion. For example: LPG gas, Petrol etc.
Prices of such commodities increases and demand does not show any tendency to
contract and it negatives the law.8

 Conspicuous and consumption

If consumers measure the desired ability of the utility of a commodity, solely by
its price and nothing else, then they tend to buy more of the commodity at higher
price and less of it at lower price. Hence, there is a direct relationship between
price and quantity demanded. For example: Gold ornaments, Diamonds and hair
paintings.9
Higher the price of the good, greater will be the prestige of the buyer in the
society. When price fall, the commodity comes within the reach of lower class
people and they tend to demand more because of demonstration effect.

 Speculation
If people expect the price of good to rise in near future, they demand more even at
higher price. And if they expect the price to fall in near future, they demand less
of it even at lower price. Thus more quantity of goods is demanded at rising prices
and less quantity of goods is demanded at falling prices. This seems contrary to
law of demand.

 Giffen Goods
If the prices of basic goods (potatoes, sugar etc.) on which the poor spend a large
part of their incomes declines, the poor increase the demand for superior goods,
hence when the price of Giffen good falls, its demand also falls. There is a
positive price effect in case of Giffen goods.10

8
https://www.coursehero.com/file/p9fb6f/Limitations-of-Demand-Law-Law-of-Demand-indicates-the-
inverse-relationship/
9
https://www.coursehero.com/file/p9fb6f/Limitations-of-Demand-Law-Law-of-Demand-indicates-the-
inverse-relationship/
10
https://www.economicsconcepts.com/law_of_demand.htm
Determinants of Demand:
Some of the important determinants of demand are as follows:
1. Price of the Product
According to the law of demand when the price of a good rise then the demand
also increase and when the price falls then demand decrease.

2. Income
Rise in a person’s income will lead to an increase in demand, a fall will lead to a
decrease in demand for normal goods.

3. Consumer Expectations
Expecting of higher income will lead to an increase the quantity demanded.
Similarly, lowering in prices of goods will decrease the quantity demanded.

4. Numbers of Buyers in the Market

The number of buyers has a major effect on total demand. As the number
increases, the demand rises. Furthermore this is true irrespective of changes in the
price of commodities.11

5. Tastes and Preferences

Our tastes and preferences change over time. In our gasoline example,
assume you start dating someone who drives an electric car and constantly
reminds you of the impact your gasoline consumption has on the environment.
You will likely begin to follow some of their habits and purchase less
gasoline. Marketing departments constantly try to influence your preferences, and
sometimes even create them. That’s because the more you prefer a product, the
more you will demand it!12

11
https://www.toppr.com/guides/business-economics/theory-of-demand/meaning-and-determinants-of-
demand/
12
https://pressbooks.bccampus.ca/uvicecon103/chapter/3-3-other-determinants-of-demand/
 A Case Study of Shale Gas and Oil
In December 2018, the United States became a net exporter of oil and gas based
fuels for the first time in decades. These fuels provide energy for transportation, home
heating and manufacturing. Much of the production boom can be attributed to
unconventional drilling operations that increase the output of shale oil and gas wells.
Hydraulic fracturing is commonly referred to as fracking. These drilling
operations pump large amounts of water mixed with sand and chemicals into a well to
break the oil and gas free from shale rock formations.
Hydraulic fracturing has been used for years in some conventional drilling
operations, but it has proven even more useful in shale wells.

Economic Theory
To better understand the need for regulation, it is helpful to first understand the
demand firms have to pollute. The law of demand states that as the price of a good or
service increases, the quantity of that good or service demanded decreases—and vice
versa. Think about this law in the context of the goods you purchase: When the price of a
good goes up (down), you naturally want to buy less (more). But why would a firm have
a demand for something seemingly harmful like the ability to pollute? The answer lies in
the cost of reducing pollution. If there is no cost for reducing pollution, firms can produce
their goods more inexpensively and earn greater profits. Economists call this derived
demand because demand is derived from the desire to avoid the cost of reducing
pollution.
The demand curve for pollution:
Price of Pollution

P2
Demand for Pollution Rights

P1
Maximum Pollution Quantity

Q2 Q1 Q-max Quantity of Pollution

 If industries do not have to put any dollars into reducing pollution, they will likely
produce the maximum quantity of pollution created by their manufacturing methods.
Therefore, if there are no limits on pollution, they will not have to pay an extra price for
this level beyond their production costs. Now assume firms are required to reduce their
pollution level by a small amount to abide by a regulation, going from Q-max to Q1. This
reduction can typically be accomplished with some inexpensive tweaks in the production
process, costing no more than P1 for each unit of reduction. However, if firms are
required to achieve significant reductions (reducing pollution to Q2), they typically
would have to buy expensive equipment—which brings a higher price tag. Therefore, the
price of lower levels of pollution is much higher, yielding a downward sloping demand
curve. Knowing the demand curve for any given pollutant allows policy makers to
establish regulations limiting the amount of harm to the environment. One way to target a
specific quantity is to sell and allow firms to trade pollution permits, where firms are
required to own a permit for each unit of pollution emitted. This is called a cap and
trade system, where a cap, or upper limit, is established on the quantity of permits at Q.

Cap and Trade System:

Capped Pollution Level
Price of Pollution

Q Quantity of Pollution
Once the quantity is fixed in the market, the price of permits will be determined by the
demand curve. Alternatively, policymakers could fix the price (P) by charging a tax on
each unit of pollution, allowing the demand curve to determine the resulting quantity.
Such a regulation is called a Pigovian tax and is used to make activities that harm the
environment more costly.
Real World Markets
While a cap and trade system and a Pigovian tax appear to both yield the same
quantity and price, this is only true if all other market conditions do not change and the
demand curve does not move. But, of course, market conditions do change and the
demand curve for pollution rights will fluctuate. This fluctuation will have major
 implications depending on whether policymakers fix the quantity and allow the price to
be determined by the markets (a cap and trade system) or fix the price and allow the
quantity to be determined by the markets (a Pigovian tax). Under a cap and trade system,
if demand increases, the price will increase from P to P’, making reductions in pollution
more costly but leaving the level of pollution constant.
Price of Pollution
P`

P
Demand Shifts Right

Q Quantity of Pollution
Under a Pigovian tax, if demand increases (shifts to the right), the price will
remain constant but the quantity of pollution will increase from Q to Q’ (Figure 5B). In
this case, pollution will increase above the desired level (quantity).

Applying Permits and Pigovian Taxes to the Real World

When designing regulations, policymakers are faced with a tradeoff: Do they
strictly control pollution levels at the risk of elevated prices (undesirable to firm profits),
or do they strictly control pricing at the risk of elevated pollution (undesirable to health
and the environment)? The choice largely depends on the type of pollution. For example,
regarding the shale oil and gas industry, environmental scientists are concerned about
drinking water near drilling wells because many of the chemicals used in the drilling
process are believed to be highly toxic. If emitted into local water sources, the impact on
human health could be devastating. When the cost of environmental damage is high,
regulators lean toward fixed quantity controls at the risk of elevated prices. Such quantity
controls may take the form of a cap and trade system, firm-level restrictions on
emissions, or even an outright ban.
With CO2, a naturally occurring chemical, regulators are more concerned about
atmospheric levels of CO2 in the long run and not necessarily in any given year. As a
result, regulators could fix the price in the form of a Pigovian tax and allow the amount of
CO2 generated to vary year to year. This would allow firms to avoid the uncertainty of
suddenly elevated prices in the market for CO2 pollution permits. Thus, it is clear that the
optimal environmental policy for any pollutant depends on its chemical formulation, its
toxicity, and the resulting costs of its environmental impact.
Conclusion
Economists often make the assumption of a “representative agent”—a single
agent whose actions are representative of all persons in the economy. Unfortunately,
there is no such thing as a representative pollutant, as each one has unique chemical and
physical properties that must be considered when designing environmental policy. For
example, the shale oil and gas industry uses and emits pollutants ranging from natural
elements such as CO2 to toxic chemicals such as those used in the drilling process.
Sound environmental policy needs to take into account the dangers of the pollutant, the
needs of the industry, and the real-world behavior of the market: If a pollutant is not
highly toxic, then a Pigovian tax can successfully reduce the long-term emission levels
while creating price stability for firms. For a more toxic element that produces greater
health concerns, a cap and trade system or other quantity control may be more
appropriate, even if it creates price uncertainty for firms.