Terms Beginning With 'l'

Law of Demand

  • November 12, 2020
  • Team Kalkine

What is the Law of Demand?

Law of demand states that the price of a good is inversely proportional to the quantity demanded of that good. This means that as prices of a good falls, ceteris paribus, the quantity demanded of that good increases, and vice versa. This happens because as goods become cheaper, more and more people want to buy them.

Law of demand helps explain how the goods market moves. Through the demand and supply curve, the goods market equilibrium can be predicted. With the help of a demand curve, the demand of a good can be estimated given its price.

What is a Demand Curve?

A demand curve plots the prices of a good against the quantity demanded of that good. Each point in a demand curve represents a combination of price and quantity that is achievable for that good. A demand curve is made with the help of a demand schedule which is a table representing the quantity demanded against individual prices.

Demand curves are downward sloping because of the negative relationship between prices of a good and its quantity demanded. Its slope varies depending on the price elasticity of demand for the good in question.

Price elasticity of demand refers to the ratio of the percentage change in quantity demanded to the percentage change in price. As the price elasticity of demand for good increases, the slope of the demand curve decreases.

It is important to note that ‘demand’ and ‘quantity demanded’ are not the same.

Demand refers to the relationship between prices of a goods and its quantity demanded, whereas quantity demanded refers to the quantity associated with a particular point on a demand curve.

Demand curves have different shapes based on different price and quantity relationships. They can be concave or straight lines; however, they are always downward sloping.

How does the demand for a good change?

The quantity of a good may change due to various factors, prices being one of them. When the prices of a good increase, people start to consume less of that good, unless that good is a necessity good. A necessity good is a type of good that cannot be removed from the consumption basket of people, even if its prices are rising. An example of this can be oil, bread and utilities like power and water.

Alternatively, the demand for a good can be influenced through various other factors like income, price of related goods, taste and preferences of the consumer and the number of consumers in the market.

Here, related goods refer to substitute and complementary goods. Substitute good is an alternative good that can be used to replace the good in question, while a complimentary good refers to another good that must be purchased along with the good in question to use it.

Keeping all other factors equal, when the price of a good changes, the change in demand curve is observed along the curve, as shown below:

Here, the negative relationship between price and quantity demanded is visible. As prices fall from P1 to P2, the quantity demanded increases from Q1 to Q2.

When factors other than price are changed, then the change in the demand curve is observed through a shift and not through a movement along the curve. In this case each factor is changed separately while all other factors are kept constant.

In the figure above, when prices are kept constant, the demand curve shifts due to changes in one of the determinants of demand other than price. However, this change ultimately leads to a corresponding change in the price.

In the scenario shown above, both price and quantity demanded are increasing. This does not mean that the law of demand is failing here. The prices have adjusted to the shift in the demand curve. As the quantity demanded shifts from Q1 to Q2, the limited supply of that good makes the prices rise. Thus, the law of demand works with law of supply to find out various allocation levels of a good in a market.

Why is there a negative relationship between the price of a good and its quantity demanded?

The relationship between the price and quantity of a good is given by the Law of Demand. This relationship exists because individuals in an economy are assumed to be rational. This means that they would want to incur as less costs as possible and gain as much profit as possible from a transaction.

This rationality explains why consumers would want to save up on their costs while purchasing a good. Therefore, when price drops for a commodity, most individuals would flock to the stores to buy that commodity, sometimes even irrespective of other factors like their tastes or preferences.

For instance, consider the scenario where there is sale on appliances of Company A. Most consumers would start purchasing the goods of Company A, even if they had previously been consuming appliances from another company.

Sometimes, people would shift to goods that were previously out of budget for them, simply because of a reduction in prices. For instance, consider an individual who does not own a car because he cannot afford it and depends on public transport instead. However, seeing a temporary dip in the prices of automobiles, he might purchase a car now than wait for him to be able to afford it in the future.

This knowledge of price and demand relationship is used by governments and monetary authorities to influence the business cycles. Prices can be raised to reduce demand by the government and can be decreased to encourage consumption of goods in the economy.

What are some cases where law of demand does not apply?

Law of demand may not apply for certain specific categories of goods. These include Giffen goods and Veblen goods.

Giffen goods refer those goods which see an increase in quantity demanded as their price increases. They are certain exceptional types of goods that form a large part of an individual’s consumption basket and lack close substitutes. An example of this can be essential items like bread. As the price of bread rises, people start hoarding more of it.

Veblen goods are the luxury goods that see increased demand as their prices increase. People attach a sense of social status to these luxury goods, which is why they buy more of that good as it becomes expensive.

What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others.  The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors.  For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel.  How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages.  Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage.  Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade.  Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries.  What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another.  The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services.  Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour.  Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television.  It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured.  Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power.  The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play.  It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability.  What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects.  The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers.  Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.

Difference between actual and an expected return. For example, if a stock increased by 7% because of some update, but the average market only increased by 3% and the stock has a beta of 1, then the abnormal return was 4% (7% - 3% = 4%)

Gain or loss as a percentage of the initial capital invested. For example – If we gain $10 on investing $100, our Absolute return would be 10% ($10/$100*100)

Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.    

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