Last Updated on: 23rd August 2024, 11:54 am
Theory of Demand
Demand
In this part, we discuss about behaviour of Demand in economic functions & analysis, relating to following points:
- Demand
- Law of Demand
- Demand Schedule
- Demand Curve
- Expansion & Contraction in Demand
- Increase & Decrease in Demand
- Elasticity of Demand
- Price Elasticity of Demand
- Income Elasticity of Demand
- Cross Elasticity of Demand
Theory of Demand in Economics
Demand refers to quantities of a commodity that the consumers are able to and willing to buy at each possible price, other things remaining same.
Demand may be defined as the desire to purchase a commodity, backed by sufficient buying power and intention to spend.
Determinants of Demand in Economics
VariousEconomic, Social and Political factors influences demand for a commodity.
- Price of the commodity: Price of commodities significantly influences the demand. As the price of a commodity changes, it causes an opposite change in the demand for the commodity. So, rise in price of goods causes decrease in its demand and vice versa.
- Tastes and preference: Tastes and preference, like fashion, habits, advertisement, culture, etc. influence the demand for special product, quality etc.
- Price of Related Goods: Demand for the commodity is also influenced by change in the price of related (complementary & substitute) goods.
- Complementary goods: Somegoods, are consumed together (e.g. car and petrol etc.), hence jointly demanded. Now if the price of the car rises, demand for car and petrol will simultaneously decline and vice versa. So, Price and demand of complementary goods are inversely related.
- Substitute goods: These are goods which can replace each other (like petrol and diesel). If the price of petrol increases, its demand will decline resulting to a rise in demand for diesel (also known as ‘cross demand’). Thus, there is a direct relationship of price and substitute goods.
- Government policy: Government policy, (e.g. tax, import or export policy) influences the demand of a commodity. When government imposes tax on any commodity, its price rises resulting to decline in its demand.
- Population Size and density:Demand for commodity in densely populated area will be more compared to less populated areas. So, density of population has a direct relationship in influencing demand.
- Distribution of income and wealth: Demand for all the commodities is likely to be high in regions having equality of income and wealth than the regions where there is great inequality between economic conditions of people.
- Economic condition: If a country is passing through a period of boom, there will be an increase in market demand. During the period of recession, the market demand will be on the lower side.
Law of demand in Economics
The Law of Demand states that other things being equal, the demand increases with a fall in price and diminishes when price increases.
The term ‘other things being equal’ implies prices of related goods, income of consumers, their tastes, preferences etc. remain constant.
Exceptions to the law of Demand
The Law of Demand does not apply in following cases
- Conspicuous consumption: There are some goods (like women’s hats) which are bought, not for their intrinsic worth, but for their “snob-appeal”. This are called “conspicuous consumption” or articles of ostentation. When prices of conspicuous consumption goods rise, their use becomes more attractive and they are bought in larger quantities. If fish becomes more expensive, some people will buy more of it just to show their high status. On the other hand, when such goods become cheaper, they are bought less. For example, higher the price of diamonds, higher is the prestige value attached to them and hence higher is the demand for them.
- Speculative markets: In speculative markets, a rise of prices is frequently followed by larger purchases and a fall of prices by less purchases. When the price of a share rises, people hope further rise and rush to purchase. When price declines, they wait for further declines and stop purchasing. Similar behaviour may be noticed in other commodities where purchases are made on speculative basis. But it is a short period event.
- Giffen Goods: Giffen found that poor spent the major part of their income on cheap necessary foodstuffs (like potatoes) and a small part on costlier goods (like meat). When the price of such cheap goods (like potatoes) rose, they had to economise on costlier goods (like meat). To fill up the daily requirement, more cheaper goods (like potatoes) had to be bought. Increase in the price of cheaper Giffen goods (like potatoes) lead to increased demand. This is known as the Giffen Effect. Such phenomenon is normally found in the case of cheap necessary foodstuffs.
- Income effect: Thedemand curve may be affected by the income effect. If the income effect is positive (i.e. income elasticity of demand exceeds zero) we can expect a downward sloping demand curve. But, if the income effect is negative, particularly in case of inferior good, the result may not be a downward sloping curve. If the total expenditure of the commodity is small, the income effect will have less implication on the demand curve and there will be an inverse relation between price and demand.
- Ignorance effect: It is assumed that a household has perfect knowledge about price and quality of goods, but household may be ignorant of the lowest ruling price of the commodity. Due to ignorance, a household may demand larger quantity of a commodity even at a higher price.
- Impulsive purchases: Impulsive purchases means ‘purchases by impression’ (e.g. purchase of chocolate, candy etc.).At times consumers tend to make impulsive purchases, without any cool calculation about price and usefulness of the product.
- Insignificant portion of income to be spent on commodity: Some commodity occupies an insignificant portion in the total budget of the consumer (e.g., salt, match boxes). Variations of its price of insignificant commodity may not cause change in demand for the commodity. In such case, real income is not changed significantly with change in price, so the curve is parallel to the price axis.
Demand Schedule
Demand Schedule may be defined as a list of different quantities of a commodity purchased at different price, depicting the relationship between quantities of the commodity demanded at respective prices.
Individual Demand schedule
It refers to the different quantities of a given commodity which a consumer will buy at various prices
| Price (Rs.) | Quantity Demanded |
| 1 | 10 |
| 14 | 8 |
| 15 | 6 |
| 16 | 4 |
Market Demand schedule
Market demand schedule refers to the quantities of a given commodity which all consumer will buy at different price at a given moment of time
| Price (Rs.) | X’s Demand (1) | Y’s Demand (2) | Market Demand schedule (1 + 2) |
| 1 | 4 | 15 | 4 + 15 = 19 |
| 2 | 3 | 14 | 3 + 14 =17 |
| 3 | 2 | 13 | 2 + 13 = 15 |
| 4 | 1 | 10 | 1 + 10 = 11 |
Market Demand Schedule exhibits the total demand of all consumers in the market at different prices of the commodity.
Demand Curve
Demand Curve is a graphic representation of demand schedule. It shows the relationship between different quantities demanded at different possible prices of the given commodity.
The Demand Curve shows the maximum quantities that the consumer will take at various prices.
Types of Demand Curve
- Individual Demand Curve: It isthe graphic presentation of individual Demand schedule. Individual Demand curve shows different quantities of a commodity demanded by a consumer at different prices.
- Market Demand Curve: It is the graphic presentation of market demand schedule. Market demand curve shows total quantities of a commodity demanded by all the consumers in the market at different prices.
Demand Curve Slopes
Inverse relationship between demand and price makes the demand curve negatively sloped, due to certain factors
- Diminishing Marginal Utility: As the consumers buy more and more quantity of a commodity, the satisfaction obtained from each successive unit goes on diminishing (called the law of diminishing marginal utility).
Consumer always attempts to maximize his satisfaction by equalizing the marginal utility of a commodity with its price. So, the consumer will buy additional units only when the price declines. Therefore the demand curve slopes downward as the marginal utility curve also slopes downwards.
- New Consumers: After decline in commodity price, many consumers, unable to purchase earlier, shall now start to buy the commodity, causing increase in demand of the commodity. So, there is an inverse relationship between demand and price, which causes the demand curve to slope downwards.
- Multiple use of commodity: Some commodities are put to several use (e.g. coal, electricity, etc.). When the prices of multiple use commodities go up, they will be used only for essential purposes and their demand will be limited. Similarly, when their price decline, they are used for varied purposes for satisfying different demands. There is an inverse relation between demand and price of multiple use commodities, which makes the demand curve slope downwards.
Change in Demand
Change in demand may be broadly classified as :
- Expansion & Contraction in demand due to Change in price
- Increase & Decrease in demand, due to Factors other than change in price
Expansion & Contraction in Demand
When the demand rises due to the decline in its price, it is called Expansion in demand, but when the demand decreases due to the increase in its prices, it is called contraction in demand. The expansion or contraction in demand is also known as movement along the demand curve/ change in the quantity demanded.
Increase & Decrease in Demand
Increase or decrease in demand due to change in any other factor, other than price, is called respectively ‘Increase in Demand’ & ‘Decrease in Demand’.
- Causes for increase in demand : Increases in income of the consumer, Increases in price of substitute goods, Fall in price of complementary goods, Consumer preference shifts, Price of the commodity is expected to increase in near future, Increase in number of consumers, etc.
- Causes for decrease in demand : Fall in income, Fall in price of substitute goods, Rise in price of complementary goods, Shift in taste & preference, Price of the commodity expected to decrease in near future, Decrease in number of consumers, etc.
Shifting of demand: When due to change in factors other than price,(like change in taste, Income etc.), the demand changes, the entire demand curve shifts either upwards or downwards. This is called a shifting of demands curve.
Relationship of Goods & changes in demand
Nature Goods & changes in demand
- Superior Goods: When the income of consumer increases, the demand for the superior goods also increases (demand curve shifts right wards). In the opposite case, the demand of superior goods declines (the demand curve shifts leftward).
- Inferior Goods: Demand for inferior goods rises with a decline in income. The whole of demand curve shifts right ward. The demand for inferior goods reduces with rise in income, causing the demand curve shift leftward.
- Substitutes: In the case of substitutes (e.g. petrol & diesel), when the price of substitute declines, the demand of commodity also reduces and therefore the demand curve shifts leftward. In the opposite case, the demand of commodity rises and the demand curve shifts rightward.
- Complementary Goods: When the price of complementary goods (e.g. car & petrol) increases, the demand for the commodity declines and the demand curve shifts leftward. In the opposite case, i.e. when the price of complementary goods declines, the demand for commodity increases and therefore the demand curve shifts rightward.
- Substitution effect: Substitution effect means the change in the consumption or demand of two commodities as a result of their relative change in prices, the total utility remaining the same.
- Income effect: When price of a commodity changes, the real income of a consumer also undergo a change. Real income denotes consumer’s purchasing power. If price of a product decreases, the real income of a consumer rises and he purchase more units of the product. The demand curve slopes downward due to this income effect. This is called income effect for change in demand.
Elasticity of Demand
Elasticity of demand refers to the effect of quantity demanded of a commodity due to change in one of the variables on which demand depends (e.g. price of commodity, price of related goods, income level etc.).
Elasticity e = (% change in the quantity demanded) / (% Change in any one of the variables of Demand)
Types of Elasticity of Demand
- Price Elasticity : Price elasticity of demand shows the responsiveness, or elasticity, of quantity demanded of a good or service to change in its price
- Income Elasticity :Income elasticity of demand shows the responsiveness of demand for goods to a change in the income of the people demanding the goods. It is calculated as ratio of percentage change in demand to percentage change in income.
- Cross Elasticity : Cross elasticity (or cross-price elasticity) of demand measures the responsiveness of the demand for a commodity to a change in price of another commodity. It is measured as percentage change in demand for the first goods that occurs in response to a percentage change in price of the second goods.
Price Elasticity of Demand
Price elasticity of demand (Ep) refers to the effect of quantity demanded of a commodity due to change in price of that commodity. It is expressed as percentage change in quantity demanded of a commodity, divided by percentage change in its price.
Price Elasticity Ep = (% change in the quantity demanded) / (% Change in price)
Symbolically, Ep = (∆q / ∆p) x (p/q), where Ep= Price Elasticity, P = Price, Q=Quantity, ∆q = Change in quantity, ∆p= Change in price.
- Price elasticity Negative : Price elasticity will be negative in case of normal goods, as there is negative relationship between demand of normal goods and its price.
- Price elasticity Positive : Price elasticity will be positive in case of giffen goods, due to the positive relationship between demand of giffen goods and its price.
Methods to measure Price elasticity of demand
- Total Outlay Method : In this method, total expenditure made by consumer after and before change in price of commodity is compared.
Point elasticity Method : Point elasticity is the price elasticity of demand at a specific point on the demand curve instead of over a range of it. - Arc elasticity Method : Arc elasticity is the elasticity of one variable with respect to another between two given points.
Total Outlay Method
Elasticity of Demand can be defined in terms of the total outlay on the commodity.
Let us assume a commodity demand changes exactly in proportion to the changes in price, as follows:
| Price (Rs) | Quantity Purchased | Total Outlay (Rs) |
| 2 | 2,400 | 4,800 |
| 4 | 1,200 | 4,800 |
| 6 | 800 | 4,800 |
| 8 | 600 | 4,800 |
| 12 | 400 | 4,800 |
Nature of Elasticity of Demand on Total Outlay
- If total outlay of the consumers on the commodity remains constant, at every price, the elasticity of demand is said to be Unity.
- If the total outlay on a commodity increases due to fall in price, the demand is said to be Elastic.
- If the total outlay is reduced due to fall in price, the demand is said to be Inelastic.
Point Elasticity Method
In Point Elasticity method, elasticity at a given point on the demand curve is measured using derivatives, rather than finite changes in price and quantity.
EP = (-dq/dp) x (p/q), where, (-dq/dp) = derivative of quantity with respect to price at a point on the demand curve. P= Price, Q = Quantity.
Elasticity of demand is different on different points on the demand curve.
Point elasticity can also be calculated as:
(Lower Segment on the demand curve) / (Upper Segment on the demand curve)
So, the elasticity of demand at point P on the demand curve DD1 is PD1/PD.
Point Elasticity Graph
Arc Elasticity Method
Arc Elasticity Method is an estimation of the average responsiveness to price change shown by a demand curve, over some finite stretch of the curve.
Since averages are taken, we use {(p1+p2)}/2 instead of p, and {(q1+q2)}/2 instead of q.
The formula for Arc Elasticity is:
Ep = {(Change in quantity demand)/(Original quantity plus quantity after change)} / {(Change in price)/(Original price plus new price after change)}
Symbolically, it can be expressed as ∆q / (q1+q2)
Ep = ∆p / (p1+p2) = (∆q / ∆p) x {(p1 + p2) / (q1+q2)}
Arc Elasticity Graph
where, ∆q=Change in quantity, ∆p=Change in price,
q1=Marginal quantity, q2=New quantity, p1= Marginal price, p2= new price
Determinants of Price Elasticity of Demand
Factors affecting the elasticity of demand for a commodity:
- Nature of commodity: The demand for a commodity depends entirely on its nature. In case of necessities, the demand is inelastic, as they are to be purchased even though their prices rise (e.g. food). On the other hand, the demand for luxuries is elastic (e.g. car). In case of luxury goods, if price increases, demand also decreases.
- Multiplicity of uses: A commodity which serves a number of purposes will have an elastic demand (e.g. Milk, electricity, etc.), whereas a commodity whose use is restricted, the demand shall be inelastic (e.g. Bicycle). Decrease in price of goods having multiple use also brings significant increase in demand of that goods.
- Substitute goods: Availability of substitute have significant impact on the degree of elasticity. The demand for a commodity having close substitute is elastic (e.g. coffee, cold drink etc.) whereas a commodity whose close substitutes are not available (like salt), the demand will be inelastic.
- Price movement expectation: If there is a prediction that price of a commodity is likely to rise in the near future, its demand shall become elastic in the present.
- Consumer habit: Consumer habitual of a certain commodity, will purchase irrespective of its price, and the demand for such goods shall be inelastic (e.g. liquor etc.). In case of addictive goods, (e.g. cigarette), price increase cannot bring significant decrease in demand.
- Postponement: If the demand for a particular commodity can be postponed for sometime, its demand will be elastic (e.g. VCR, Washing machine etc.). If price goes up, people try to postpone its purchase & its demand fall significantly. On the other hand, demand for foodgrains, medicines, etc, is inelastic as their consumption cannot be postponed.
- Durability: In case of durable goods (e.g., a furniture), a change in price would not affect demand very much. Consumers normally will not buy new Item until the old one is totally worn out. Therefore, durable goods usually have low elasticity of demand.
- Income level: People who have more purchasing power may not change quantity demanded even if price changes. On the other hand for poor people, demand is more sensitive to change in price.
- Proportion of expenditure: Commodities for which consumers spend a very less portion of income (like match boxes, salt) have very inelastic demand. Even substantial change in their price will not cause enough impact to his demand.
Degree of Price Elasticity of Demand
Degree of Price Elasticity of Demand
- Perfectly Elastic: When a small fall in price leads to infinitely large purchases, demand is said to be Infinitely Elastic or Perfectly Elastic (E = µ ).
- Elastic: When a small fall in price leads to a large but a finite increase of purchases, demand is called Elastic (E< µ and >1).
- Unitary Elastic: When a change of price causes an exactly proportional change of demand, demand is called Unitary Elastic (E = 1).
- Inelastic: When a fall of price reduces total outlay but not to zero, demand is Inelastic (E<1 and > 0).
- Perfectly Inelastic: When a change of price causes no change in the amount purchased, demand is said to be Infinitely Inelastic or Perfectly Inelastic (E = 0)
Degree of Price Elasticity of Demand
Income Elasticity of Demand
Income Elasticity of Demand (EI) measures the responsiveness of quantity demanded of a commodity, to a change in Consumers’ Income, when all other factors (Price of the Commodity, Substitutes, and Prices of Related Commodities) are constant.
EI = (% Change in Quantity Demanded / % Change in Consumers’ Income)
= {(Change in Quantity) / (Original Quantity)} x 100 / {(Change in Income) / (Original Income)} x 100
= {(Change in Quantity) / (Original Quantity)} x {(Original Income) / (Change in Income)}
= {(∆q/q) x (i/∆i)}.
Symbolically, EI = (∆q/∆i) x (i/q)
where, q = quantity, i = Income, ∆q = change in Quantity, ∆I = change in Income.
Generally, Income Effect is positive, so Income Elasticity of Demand is also positive. However, there may be negative Income Elasticity in case of Inferior Goods.
Degree of Income Elasticity of Demand
Perfectly Inelastic : There is no impact of change in income on the demand of a commodity (ei = 0)
Inelastic : % Change in quantity demanded <% change in income (0< ei<1),
Unitary Elastic : % Change in quantity demanded = % Change in income (ei = 1)
Elastic : % Change in quantity demanded > % change in income (0> ei>1),
Perfectly Elastic : Small change in income (tending to zero) causes substantial change in quantity demanded (ei = µ)
Income Elasticity of Demand and Types of Goods
Income elasticity of demand measures the responsiveness of demand to a change in income.
- Inferior Goods: Inferior goods means an increase in income causes a fall in demand. It has a negative ei. When income rises, people buy less of such commodity, and more of superior quality.
- Normal Goods : Normal Goodsmeans an increase in income causes an increase in demand. It has a positive ei. A normal good can be income elastic or income inelastic.
- Luxury Good. Luxury good means an increase in income causes a bigger % increase in demand. It means that the ei is greater than one. When income rises, people spend a higher % of their income on the luxury good. (Note: a luxury good is also a Normal Goods, but a normal goods isn’t necessarily a luxury good)
Cross Elasticity of Demand
Cross elasticity of Demand refers to the effect on demand of a commodity due to change in the price of other goods (substitute or complementary).
Cross Elasticity EC= (% Change in the quantity demanded) / (% change in the Price of other commodity)
EC =(∆qx/ ∆py) x (py/qx)
Where, qx=Quantity demanded of commodity X, ∆qx = Change in the quantity demanded of commodity X, py =Price of commodity Y, ∆py = Change in the price of commodity Y
- Positive cross elasticity of demand implies substitute goods, like Tea & Coffee, Red Pencil & Blue Pencil, Coke & Pepsi etc.
- Negative cross elasticity of demand exhibits complementary goods, like Car & petrol, Tea & Sugar, Pen & Ink etc.
- ‘Zero’ cross elasticity implies that goods are not related to each other.
Examples
- If the quantity demand A increases by 10% when the price of B increases by 20%, the cross price elasticity of demand between X and Y will be:
EC of AB commodity = A = 10% / 20% = + 0.50. EC (+0.50) indicates that A and B are substitute goods.
- If the quantity demand of A increases by 10%, when the price of B decreases by 20%, the cross price elasticity of demand between A and B will be:
EC of AB commodity = %∆QA / %∆PB = 10% / 20% = -0.50 EC (-0.50) indicates that A and B are Complementary goods.
Utility of Elasticity of Demand
Elasticity of Demand is useful for :
- Foreign Trade: Government imposes a higher tax rates on goods having inelastic demand, and a lower tax rate for goods having elastic demand.
- Demand Forecasting: It is possible to forecast the demand for a particular commodity by analyzing its elasticity.
- Price Fixation: The concept of elasticity assists a monopolist in determining prices for his product. He will settle up a higher price in those markets where demand for his product is inelastic. Conversely, he will fix a lower price for the same product in some other market, where demand is elastic.
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