DEMAND ANALYSIS

Demand refers to the quantity of goods and services which consumers are willing to buy at each
specific price in a given market at a given time. A consumer can be characterized by many
factors such as sex, age, lifestyle, wealth, parentage, ability, intelligence. Three important
characteristic are the consumption set, initial endowment, and preference relation.
Consumption set refers to all the available consumption alternatives that a consumer has and
sometimes it is called the choice set. The initial endowment refers to the amount of various
goods that a consumer has and can consume or trade with other individuals. Preference relation
specifies the consumer’s tastes or satisfaction for different object of choice. A consumer behaves
in a manner that seeks to identify and select an available alternative that is most preferred in the
light of his or her personal tastes and interests.

In the analysis of consumer demand, the main questions asked are

 What happens to consumer demand when prices and income change?
 What happens to consumption bundles when prices and incomes change?
To answer these questions, it is first necessary to make some assumption about the behaviour of
the consumers.
 The consumer has full knowledge of the available alternatives in the market.
 The consumer behaves in a manner to maximize his/her utility subject to the budget
constraint.
 The consumer can rank his choices consistently
 The consumer can compare the available choices in the market
 The consumer has many wants but limited resources
 Consumer prefers more to less.
Based on these assumptions, it is possible to model the consumer behaviour. Taking the positive
orthant / quadrant of the Euclidean space
food

0 Non food

The consumer will consume all the combination s of goods and services in this quadrant. Given
that the consumer prefers more to less an increasing amounts of the consumption bundle is
preferred.
Assuming that there are two goods in the consumption bundle, the combinations of consumption
bundle that a consumer would prefer would give his indifference curve.
What is the least amount of goods that a consumer would prefer? How much of the food will he
exchange for non food? Which combination is he comfortable with? These would give a locus of
points from which a consumer’s indifference curve can be drawn and this would reveal his
preferences.

INDIFFERENCE CURVES
By plotting the various combinations of food and non food that a consumer prefers, an
indifference curve can be plotted. It shows the preferred bundle.
Since consumers can rank their preferred choices, the set of indifference curves can be drawn
and they don’t cross each other. The indifference curves are drawn in a manner that shows
increasing difficulty of substituting one commodity for another as more and more of the first
commodity is taken away. This decreasing rate of commodity substitution is quite characteristic
of most consumption circumstances.

BUDGET LINE
Financial resources constraint limits the choices that a consumer can make. There is a limit
beyond which they can’t continue consuming. This is the budget constraint/ limit
HOW THEN IS A CONSUMER’S UTILITY MAXIMIZED?

To maximize utility, the indifference curves must be tangent to the budget constraint. The point
of tangency gives the combinations of consumption goods (consumption bundle) that maximize
utility of the consumer. In as much as the consumer is free to choose, the choices he makes are
limited by or depends on
 Consumer income
 His preferences
 Commodity prices

IMPLICATION OF THE FREE CHOICE MODEL.

Subject to the factor governing demand, the consumer free choice model has the following
implication
1) The budget line and the indifference curves imply that all consumers who actually
consume the commodities have the same rate of substitution between the commodities.
Although the indifference curves are unique for each consumer/ individual, the same is true for
all income levels; all consumers face the same relative prices and have the same slope to the
budget line.
At equilibrium, where the consumers have just reached their highest indifference curves, the
budget line and the indifference curves are just tangent, and all consumers have the same rate of
commodity substitution. The rate is the same as the relative prices of the commodities. For small
changes, one commodity substitutes for another at the same physical rate and their relative prices
for physical quantities. For larger substitution shifts, the degree of curvature of indifference
curves is important
2) Welfare implication; consumers should be provided with an equal or fair share of the
societies economic output. This is certainly a legitimate way to divide the pie (read-national
cake).
The figure below shows how the society provides each of its two citizens with equal rations of
food and non-food. The citizen A receives F A food and NFA while B receives FB food and NFB.
If both citizens have identical tastes and preferences, they will be content with their rations
because they have the same indifference curves passing through points A and B.

if they have different tastes and preferences then their indifference curves would be different say
IA and IB. Both indifference curves will pass through point AB but this point is inferior not
optimal and does not maximize their utility.
Assuming that their initial endowment is AB ration for the two consumers that no trading is
permitted, then both A and B are restricted to I A and IB. But this does not maximize their utility.
Citizen A may discover to his delight that B is fed up with too much food in his bundle and
craves for more non food. A may find to her delight that more food is welcomed and that parting
with a little non food a minor inconvenience. If some ratio can be worked out, A and B would be
better off by trading part of their rations to each other with A giving up non-food for more food
and B receivive the non-food in return for the food the y give up.
After trade A and B move to higher indifference curves, a situation that improves their well
being.
The most efficient way to bring about redistribution is therefore through the market.
Why is the government rationing a popular policy intervention measure?
The answer lies not in the gains/losses from trading but in the transfer of real purchasing power
to consumers by distributing evenly or fairly a limited supply of an important commodity. Poor
people with little purchasing power would be unable to purchase adequate supplies of scarce
commodity if high market prices are used to allocate instead of per capita rations.

WHAT HAPPENS WHEN INCOME CHANGES INCOME ELASTICITY OF DEMAND.

With an increase in income, more of food and non-food would be consumed. The increase can be
illustrated with the diagram below.

Here there is more money to buy purchase more of both commodities but the question is, does it
mean that an increase in income would automatically lead to an increase in consumption of the
two bundles?

There are two possibilities

 As income increases more of one or both commodities would be consumed.
 As income increases, less of one or both commodities would be consumed.
The commodities whose consumption declines as income increases are known as inferior goods
and local examples are cassava and potatoes. The commodities whose consumption increases as
income increases are known as normal goods and a local example is bread.

The rate of increase in consumption of food is usually rapid at low income levels but this falls
gradually at high income levels. This shows that the low income group tends to use large share of
their income on food while the high income group tends to use a relatively small amount of their
income on food. This phenomenon is characteristic of the ENGELS law. Engel’s’ curves are also
known as income consumption curves.
For this group of Engel’s curve note that
 Consumption of jewels is zero at low income group
 Change in expenditure on food for low income household is high but low for the high
income households
  Housing expenditure increases proportionately to income after some initial levels
 Expenditure on jewelry increase proportionately to income increase

The relative degree of increase in consumption as income increases is quantified by income

elasticity of consumption.

Change in food consumption

Income elasticityoffood =
Change in income level
For example if food consumption increases by 20% following n income increase of 50%, then
the income elasticity of food consumption is given by
20
0.4 =
50
Two important characteristics of income consumption are
 They are unique to each individual household, they are not the same
 They are not constant. They change with changes in prices as well as income.

WHAT HAPPENS TO CONSUMPTION WHEN PRICES CHANGE? PRICE ELASTICITY .

An increase in price leaves the consumer with decreased/ reduced consumption opportunities.
The consumer adjusts by reducing the amounts in their bundles of choice. They would however
wish to retain their original consumption level that maximized their utility subject to their budget
constraints.
Price changes have two effects on the consumer
 Income effect
 Substitution effect
INCOME EFFECT.
Income effect comes about due to change in the quantity of goods and services purchased
following a gain or loss of utility. An increase in prices at a constant income level makes the
budget line to move inwards to a lower level of utility. This is equivalent to a drop in the
purchasing power of money. This drops the real income and the consumers’ consumption bundle
that would maximize his utility would be lowered to a lower budget line.

SUBSTITUTION EFFECT.
However, despite the decline in the purchasing power of the consumers’ income, the consumer
would always wish to retain his initial level of utility. To maintain this level, the consumer has to
purchase a small amount of the more expensive commodity. This is exactly what he would do if
he was compensated.
A fall in price of X makes the consumer to buy more of it. The additional amount bought is given
by the amount on the horizontal axis A’B’, identical horizontal distance between points A and B.
the amount A’B’ is the total effect of price change.
In a bid to maintain the utility of his consumption bundle, the consumer would want to (would
prefer to) maintain his previous indifference curve but buying more of the cheaper commodity.
He thus moves from point A to point C. Point C is a tangent point that gives a budget line
parallel to the new one but on his earlier indifference curve.
This point in his previous indifference curve gives him a rate of substitution similar to the one
under the new price level.
What then is the total effect of price change?

Total effect= substitution effect+ income effect

SUBSTITUTION EFFECT.
This is always negative since a price increase is always accompanied by a decrease in the
quantity consumed.

. Goods whose consumption increases with increase in income are known as normal goods.
This can either be positive, zero or negative.
It is positive and zero when an increase in income leads to increased consumption. Goods whose
consumption increases with increase in income are known as normal goods. Alternatively, the
income effect would be negative when an increase in income leads to a decline in consumption.
Goods whose consumption decreases with increase in income are either inferior goods or giffen
goods. If the magnitude of decline is smaller than the substitution effect, then the goods in
question are inferior goods. However, if the magnitude of decline is larger than the substitution
effect, then the goods in question are giffen goods.
SLUTSKY EQUATION.

From the foregoing discussion, it is clear that a fall in price has two effects, substitution effect
and income effect. Substitution effect occurs when one commodity becomes less expensive and
the income effect refers to the total purchasing power which changes. This equation summarizes
consumption of goods and services by relating total change in consumption to change in
commodity price. Consumption of substitutes increases when commodity prices increase.

e ij =ε ij− Ei α j
e ij=Overall demand elasticity for com modity i when the price of j changes
ε ij=Pure substitution elasticity for com modity i when the price of j changes
E i=Income elasticity for com mod ity i
α j =Budget share of com mod ity j in the consumers total exp enditure in all com modities