Accumulated Demand and Recovery of Losses

Consumer Behavior:

Accumulated Demand and Recovery of Losses

Let’s Recap: “Economics is a social science that deals with allocation of resources and concern with production, distribution, and consumption of goods and services.”

The utility of a good determines its demand and productivity of labor and capital determine its supply, and subsequently, equilibrium is determined in the economy.

But, in this micro-economic equilibrium setup, we often disregard one important component of demand and that is ‘taste’. Consumer preferences are defined as the subject of their taste of various bundles of goods.

Tastes and preferences of consumers are very important in micro-economic analysis, especially in the short-run.

Why not in the long-run?

Because of their volatility and erratic nature.

‘Tastes and Preference’ often impact demand and supply in the short run and especially when there are temporary supply disruptions such that the good becomes scarce in a particular market area. In such a case, tastes and preferences associated with that good minimize the loss incurred in the scarcity period due to accumulated demand (D^A), if and only if the good is a non-essential normal good (a luxury good).

These supply disruptions could be due to unfavorable environmental conditions, unavailability of raw materials, transportation delays, temporary labor shortages or any short-term impediments.

 

Theory of Accumulated Demand

Assumptions:

·         The consumer is a rational consumer.

·         Good is a non-essential normal good.

·         Price of the good remains constant (otherwise also non-essential goods are generally more price elastic, so industries avoid changing prices in the short-run)

·         Purchasing power of the consumer remains constant.

·         Tastes and Preferences of the consumer remains the same.

·         The Consumer has complete market information.

·         The Quality of the good remains the same.

Statement: When a non-essential good (satisfying non-essential needs) becomes scarce in the market (i.e. supply fell drastically) in the short-run (for the short period of time), the individual demand for that good tend to accumulate during that period (known as accumulated demand), and when the supply of that good starts to restores, this accumulated demand tends to increase the consumption of that good to a level more than normal.

D^A = f (t, T, U)            

[t: Time period of scarcity; T: Taste and Preferences, U: Utility of the scarce commodity]

 

Why and how it happens?

Let’s first understand why only ‘luxury goods’ and not the essential goods.

Assuming that a good is a necessity commodity, then its demand will restore eventually as supply restores as utility associated with that good remains the same for the individual.

Above case is depicted in the graph below:

Supposing average consumption per week per individual to be 1 and suddenly at T₁ supply channels get disrupted. The good becomes scarce in the market and consumption per individual starts to decline due to the unavailability of the good. At T₂, the consumption has fallen to a minimum level. T₂ could be a period of time or a point of time depending on the level of scarcity and time taken to restore the supply. From T₂ to T₃, supply begins to restore, and eventually at T₃ consumption comes back to the normal level.

This happens because the consumption of essentials generally remains at a normal level only (want satisfying capacity do not change) with income and price remaining constant.

But when we talk about non-essential goods or luxury goods, scarcity tends to decrease the consumption and hence the utility of that commodity starts to increase for the individual consumers. It increases in such a way that industrial loss occurred during supply disruption is compensated when supply gets restored.

Above case is depicted in the graph below:

Again, supposing average consumption per week per individual to be 1 and suddenly at T₁ supply channels get disrupted. The good becomes scarce in the market and consumption per individual starts to decline due to the unavailability of that good. At T₂, the consumption has fallen to a minimum level. From T₂ to T₃, supply begins to restore, and eventually at T₃ consumption reaches a normal level. It keeps on growing from T₃ till it reaches a maximum point ‘M’ at T₄ (with price and income constant). This happens due to an increase in the utility of that commodity. The satisfaction derived by the consumer from that good increases for the time when supply restores (Want satisfying capacity has increased). From T₄, it comes back to the normal level at T₅ due to diminishing marginal utility.

The Utility is the driving force of demand.

Here, D^A = Recovery of loss from individual consumer

So, Net Loss to the industry (per consumer) = (L - D^A)

In general, Net Loss to the industry will be [(L₁ - D^A₁) + (L₂ - D^A₂) + (L₃ - D^A₃) + … + (L_n - D^A_n)]

[ where n = number of consumers]

The height of T₄ is a function of individual ‘taste and preferences’ and higher the consumption at T₄, more will be the loss recovered.

In a perfectly competitive market, the height of the point M will be more than that in an imperfectly competitive market due to the availability of substitutes, but in both cases ‘Theory of D^A’ will stand true.

Tastes and Preferences of a consumer make the good less substitutable and the industry less worse-off in such unforeseen circumstances where supply gets disrupted.

Implication: Post-COVID Accumulated Demand

Can this theory be applicable in the Post-COVID world for non-essential goods when supply channels get restored?

No.

Why?

Because of the basic assumption of ‘purchasing power of a consumer remains constant’. Currently, we are in T₂-T₃ phase where consumer confidence is low due to COVID outbreak and his tastes and preferences have also changed. Here, firms are laying off workers to cover the losses incurred in the lock-down period (T₁-T₂). And due to this, demand is falling further (low income), taking more time to reach the normal consumption level.

If companies would have chosen the other alternative of not laying off workers and waiting for D^A to work, then in near future demand would have restored faster, making firms less worse off. (that is why flattening of the COVID curve is very important)

But the problem here is that we are spending too much time in T₂-T₃ phase which reduces the implications of this short-run concept.

When the vaccine will be introduced in the market, consumer confidence will start to restore and his taste and preferences will be backtracked. But then the problem will be the ‘reduction in the purchasing power’ of the consumers due to reduced income in the lock-down, rising unemployment (or salary cuts) and some due to higher medical expenses in the treatment of COVID (there will be millions of such families).

There will be some industries that will gain the momentum faster due to D^A of its stronger consumer base whose purchasing power will not be affected much (servicemen or those whose savings didn’t affect their living standard), but most of the industries will face heavy losses and even shutdowns. This happens because a change in the purchasing power of consumers affects their living standard and taste and preferences.

Author: Gautam Sodani