Unit-2

Theory of Demand

Theory of Demand

If necessity is the mother of invention, then demand is the mother of production.

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A Bit of History…

Leon Walras (1834-1910) a French economist, gave demand theory as a fundamental principle of microeconomics which gives the analysis of the relationship between the demand for goods or services and prices or incomes.

The theory was subsequently developed by English economist Alfred Marshall (1842-1924), Italian Vilfredo Pareto (1848-1923), Soviet Eugen Slutsky (1880-1948), American Kenneth Arrow (1921- ) and the French-born Gerard Debreu (1921- ).

-economyprofessor.com

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What is Demand ?

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Demand is the basis of all productive activities. Demand theory is an economic theory that concerns the relationship between the demand for goods and their prices; it forms the core of microeconomics. Demand theory examines purchasing decisions of consumers and the subsequent impact on prices.

The generation of demand can be pictorially shown as below,

NEED WANT DEMAND

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Concept of effective demand

Desire to buy

Willingness to

pay

Ability to pay

Want Demand

Demand in economics means effective demand, which can be defined as a desire backed by willingness and ability to pay for a particular product. Thus for demand to effective three factors are important.

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Demand

Law of Demand Hedonic theory

The law of demand is normally depicted as an inverse relation of quantity demanded

and price: the higher the price of the

product, the less the consumer will

demand, ceteris paribus ("all other

things being equal").

It is an economic theory that the

price an individual will pay for a good reflects the sum of the characteristics

of that good.

Law of Demand

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The quantity purchased of a good or service is inversely related to the price, all other things being equal (ceteris paribus)

The Law of Demand

Price changes lead to qty demanded changing.......

Represented by movements along demand curve.

Inverse relationship between price and quantity demanded gives rise to a downward- sloping demand curve.

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DD

Price

Quantity/wk

A

B3

2

5 15

negative slope

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Demand can be perceived from an Individual demand market point of view:

Individual demand: The quantity of a good or service that an

individual or firm stands ready to buy at various prices at a given time

Market demand The sum of the individual demands in

the marketplace

Determinants of Demand• Income of the consumer: Consumption is influenced by the

income of a consumer. With every increase in the income of a consumer , his consumption pattern changes i.e, the purchasing power of the consumer increases. On the other hand any increase in the prices of product reduces the purchasing power of the consumer.

• Price of the substitute product: A substitute product is one that provides the same level of satisfaction as the product already being consumed by the consumer. Assume that two products A and B are perfect substitutes for each other. If the price of a product goes up, while B remains constant, consumers will switch to product B. For ex, with the technological advancement in the telecommunication sector, wireless in local loop is being considered as a substitute for cellular phone in the long run. Similarly bio fertilizer proved to be good substitute for chemical fertilizers.

• Price of complementary product: Complementary products are products that are consumed together . For ex, car and petrol or shoe and polish etc. In this case if the price of one product goes up the demand for the other product decreases.

• Changes in policy: The demand for a particular product also depends upon government policies. For ex, if the govt increases taxes on products, price increase and hence the demand decreases in the short run.

Change in govt policies may also have a negative impact on the demand for a particular product. The AP government’s ban on Gutkha had a negative impact on the demand for tobacco in Andhra Pradesh. Now the tobacco industry in AP is facing over supply as a result of lack of demand for tobacco products and hence the companies operating in this industry have to search for newer markets in other states.

• Tastes and preferences of the consumer: Tastes and preferences of the consumer also affect the demand for a product. To an extent, prevailing fashion, advertising and an overall increase in standard of living influence consumer tastes. When multinational fast food chains like Pizza Hut and Mc Donald’s entered India, they found that their products did not cater to the Indian tastes. The use of beef and pork is not widely acceptable in India. These companies had to alter their menu to make it more suitable to Indian consumers.

• Existing wealth of the consumer: While considering the purchasing power of the consumer, current income is not the only factor that brings about a shift in the demand curve. The existing wealth of the consumer can be in the form of stocks, bonds, real estate etc, which can be used to purchase goods.

• Expectations regarding future prices changes: If a consumer expects a fall in the price of product in the near future he may reduce his present consumption of that product. However, the extent to which he can reduce his present consumption depends on the nature of the product. If the product is essential or perishable one, the consumer cannot postpone his purchase. For ex if reduction of petrol prices is expected in near future consumers tend to postpone their purchases. However, they can do it only for a certain period because petrol being a commodity of regular use, its requirement cannot be postponed for too long.

• Special influence: Demand is also influenced by factors like climatic changes, demographic changes etc. Certain factors may affect the demand only for a particular product. For ex the demand for woolen garments goes up only a winter. In India the demand for cars is influenced by various factors like per capita income, introduction of new models, availability and cost of car financing schemes, prices of other models of cars, prevailing duties and taxes, depreciation norms , fuel cost, public transport facilities.

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Demand Schedule: A demand schedule is a tabular presentation of the amount of goods consumers are willing and able to buy at different level of prices over a given period of time.

Demand Curve: The graphical representation of demand schedule is the demand curve. The demand curve is a downward sloping curve from left to right. This characteristic of the demand curve is due to the inverse relationship between price and quantity demanded.

Price per cassette Rs.

ABCDE

A Demand Table

DVD rentals demanded per

week

0.50 1.002.003.004.00

98642 Pr

ice

per D

VDs

(in ru

pees

)E

D

C

BA

G

1 2 3 4 5 6 7 8 9 10Quantity of DVDs demanded (per week)

Demand for DVDs

6.00 A Demand Curve

5.00

4.00 3.503.00

2.00

1.00

.50 F

Nature of Demand curve:• A Demand Curve is a graphical representation of the

relationship between price and quantity demanded (ceteris paribus). It is a curve or line, each point of which is a price-Quantity. That point shows the amount of the good buyers would choose to buy at that price.

• The Law of Demand states that when the price of a good rises, and everything else remains the same, the quantity of the good demanded will fall.

• “Everything else remains the same is an assumption. In this context, it means that income, wealth, prices of other goods, population, and preferences all remain fixed.

Variation & Changes in Demand Curve• The law of demand explains the effect of only-one factor

viz., price, on the demand for a commodity, under the assumption of constancy of other determinants.

• In practice, other factors such as, income, population etc. cause the rise or fall in demand without any change in the price.

• These effects are different from the law of demand. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity.

• In economic theory a distinction is made between (a) Variations i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and decrease in demand due to other factors.

a) Variations in demand refer to those which occur due to changes in the price of a commodity.

•These are two types.•Extension of Demand: This refers to rise in demand due to a fall in price of the commodity. It is shown by a downwards movement on a given demand curve. •Contraction of Demand: This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve.•In figure A, the original price is OP and the Quantity demanded is OQ. With a rise in price from OP to OP1 the demand contracts from OQ to OQ1 and as a result of fall in price from OP to OP2, the demand extends from OQ to OQ2.

(b) Changes in demand imply the rise and fall due to factors other than price.

•It means they occur without any change in price. They are of two types.•Increase in Demand: This refers to higher demand at the same price and results from rise in income, population etc., this is shown on a new demand curve lying above the original one. •Decrease in demand: It means less quantity demanded at the same price. This is the result of factors like fall in income, population etc. this is shown on a new demand lying below the original one. •In figure, B an increase in demand is shown by a new demand curve, D1 while the decrease in demand is expressed by the new demand curve D2, lying above and below the original demand curve D respectively. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP.

Increase in demand/Forward Shift.• When more of a commodity is brought than

before at any given price there is an increase in demand. It signifies either that more will be demanded at a given price or same quantity will be demanded at a higher price.

• An increase in demand really means that more is now demanded than before at each and every price. Hence, the demand curve shifts to right.

Reasons for increase in demand.• Changes in fashions• Increase in the income of the consumer• A rise in the prices of substitutes• A fall in the prices of complementary goods.• If the people expect that price will rise in future.• Increase in population• Effect of increased advertisements.

Decrease in Demand/Backward shift.

• A decrease in demand signifies either less than will be demanded at the same price or the same quantity is demanded at a lower price.

• Decrease in demand really means that less is now demanded than before at each and every rise in price.

• In this case the demand curve will shift to the left or backward shift.

Reasons for Decrease in demand/Backward shift.• A good has gone out of fashion or the tastes of

people for a commodity have declined.• Income of the consumer has fallen • The prices of the substitutes of commodity have

fallen• The prices of the complements of the commodity

have risen• If the people expect that the price of a good will

fall in future which will affect their demand in the present period.

Following are the exception to the law of demand• 1. Giffen’s Paradox: A paradox is a foolish or absurd

statement, but it will be true. Sir Robert Giffen, an Irish Economists, with the help of his own example (inferior goods) disproved the law of demand.

• The Giffen’s paradox holds that “Demand is strengthened with a rise in price or weakened with a fall in price”.

• He gave the example of poor people of Ireland who were using potatoes and meat as daily food articles. When price of potatoes declined, customers instead of buying greater quantities of potatoes started buying more of meat (superior goods).

• Thus, the demand for potatoes declined in spite of fall in its price.

• 2. Veblen’s effect : Thorstein Veblen, a noted American Economist contends that there are certain commodities which are purchased by rich people not for their direct satisfaction, but for their ‘snob – appeal’ or‘ ostentation’.

• Veblen’s effect states that demand for status symbol goods would go up with a arise in price and vice versa.

• In case of such status symbol commodities it is not the price which is important but the prestige conferred by that commodity on a person makes him to go for it.

• More commonly cited examples of such goods are diamonds and precious stones, world famous paintings, commodities used by world figures, personalities etc. Therefore, commodities having ‘snob – appeal’ are to be considered as exceptions to the law of demand.

• 3. Fear of shortage : When serious shortages are anticipated by the people, (e.g., during the war period) they purchase more goods at present even though the current price is higher.

• 4. Speculation: When people speculate about changes in the price of a commodity in future, they may not act according to the law of demand. In the stock exchanged market some people tend to buy more shares which their prices are raising, in the hope that the rising trend would continue, so they can make a good fortune in future.

• 5. Snobbish Feeling: Some times people buy even at a higher price because of the irrational feeling that by paying a higher price they will be consuming a better commodity.

• 6. Ignorance: Customer’s ignorance is another exception to the law of demand. Sometimes consumers pay a higher price for a commodity because they will be ignorance of market condition.

Elasticity of Demand

• The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices.

• As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price).

• Elasticity is the proportional [or percent] change in one variable due to the proportional change in another variable. Therefore, elasticity is:

E = % change in x / % change in Y• When the proportional change in one variable is equal

to proportional change in the other variable, it is called unit elasticity E=1

• When E>1 , it is called relatively elastic.• When E=0 , it is called perfectly inelastic.• When E=∞, it is called perfectly elastic.• When E<1 , it is called relatively inelastic.

Price Elasticity of Demand• Price elasticity of demand measures the degree of correlation

between demand and price.• Price elasticity of demand is defined as the percentage change in

quantity demanded of a product due to the percentage change in its price, other thins remaining same.

Proportionate change in Quantity Demanded Ep = _____________________________________

Proportionate change in Price.

• The price elasticity of demand measures the change in the quantity demanded for a good in response to a change in price.

• Measures the responsiveness of quantity demanded to changes in a good’s own price.

Different Degree of Price Elasticity of Demand• 1.Perfectly Elastic Demand: No reduction in price

is needed to cause an increase in quantity demanded, in perfectly elastic demand.

• Perfectly elasticity is infinite when a small rise in price may result in the contraction of demand even to zero and a small fall in price may result in the extension of demand to unimaginable condition.

• 2. Perfectly Inelastic Demand: When a change in price causes no change in quantity demanded, demand is said to be perfectly inelastic.

• Elasticity in such cases is zero and the demand is insensitive or non-responsive to price changes.

• Hence a large fall in price does not increase the quantity demanded and a large rise in price does not decrease the quantity demanded.

• 3. Relative Elastic Demand: It is a situation in which a small change in price will lead to a big change in the quantity demanded.

• Hence a small proportionate change in the price of a commodity is accompanied by a large proportionate change in its quantity demanded.

• 4. Relatively Inelastic Demand: It is a condition in which a big proportionate change in price results in a small change in the quantity demanded.

• It refers to a condition where a change in price causes a less than proportionate change in quantity demanded.

• 5. Unitary elastic demand: It is situation in which a change in price will result in an exactly equal change in the quantity demanded.

• Elasticity of demand is unitary or one when a given proportionate change in price causes an equally proportionate change in quantity demanded.

Significance of Price Elasticity of Demand• Profit maximization requires that business set a

price that will maximize the firm’s profit• Elasticity tells the firm how much control it has

over using price to raise profit

• If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be Relatively elastic• An increase in price will reduce total revenue• A decrease in price will increase total revenue

• If Ep < 1, then the % change in Qd < % change in price, and demand is said to be relatively inelastic• An increase in price will increase total revenue• A decrease in price will decrease total revenue

• If Ep = 1, then the % change in Qd = % change in Price, and demand is said to be unit elastic• An increase in price will have no impact on total

revenue• A decrease in price will have no impact on total

revenue

Factors determining price elasticity of demand:• Availability and closeness of substitutes: Those

products which have fewer close substitutes, tend to have lower price elasticity than those having more good substitutes. In other words fewer the close substitutes, less elastic the demand for the product. For ex, Demand for utilities like water and electricity is relatively inelastic because consumers have no choice. Consumers have to buy the same even at higher tariffs. On the other hand, if movie theaters raise their ticket prices, consumers can see movies at home on a VCD players or cable television or may even switch to other forms of entertainment.

• Proportion of income spent on the product: Demands tend to be inelastic for those products and services that account for a small proportion of consumer’s total expenditure. In contrast even a small rise in the price of a product that accounts for a large part of the consumer’s expenditure make them evaluate that expenditure. For ex, a major increase in price of product like sugar will not have a major impact on a consumer’s expenditure.

• Time period: Demand is more elastic in the long run than in the short run. Longer the time period considered , more would be the chances of consumers substituting the product under considerations with a cheaper substitute. For ex, if the price of petrol keeps on increasing with diesel prices remaining unchanged , consumers would replace their petrol cars with diesel cars in the long run.

• Uses of the product: The price elasticity of demand would be higher for those products which have large number of uses. Consumers rank various uses of a product in the order of their importance. When the price of the product increases consumers may buy few units of that product for its most important uses.

• Habit formation: Some products are consumed more due to habit of consumers like cigarettes and alcohol. The demand for such product is relatively inelastic, since the consumers form a habit of consuming them.

Income Elasticity of Demand• Definition: Income elasticity of demand measures the degree or

the rate of change in quantity demanded of a good when there is some change in the consumer’s income. It measures the response of the quantity sold to a change in consumer’s income.

• A measure of the extent to which the demand for a good changes when income changes, ceteris paribus.

Ei= % Change in Quantity Demanded % Change in Income

If income elasticity of demand Ei > 1 the demand for the good is income elastic, then the % Change in demand is more than the % Change in income.

If income elasticity of demand Ei is between 0 and 1, the demand is income inelastic, then the % Change in demand is less than % Change in income.

If income elasticity of demand Ei< 0 the demand is negative income elastic,

Income Demand for normal goods

D

D

Y1

Y2

Y3

M1 M2 M3O

Quantity demanded

Income

Income Demand for an Inferior goods

Y1

Y2

M1M2

D

D

Quantity demanded

Income

O

Kinds of Income Elasticity• Zero Income Elasticity of Demand: This refers

the situation where a given increase in the income of the consumer does not result in any increase in demand. The quantity brought of the commodity remains constant.

• Negative Income Elasticity of Demand for Inferior goods: This refers to that situation where a given increase in the money income of the consumer is followed by a actual fall in the quantity demanded of commodity. For inferior goods generally income elasticity will be negative.

• Unitary Income Elasticity of Demand: In this cause the proportion of the consumer’s income spent on the commodity in question is exactly the same both before and after the increase in income. The income elasticity of demand here is equal to unity.

• Income Elasticity of Demand Greater than Unity: In this situation the consumer spends a greater proportion of his money. Income on the commodity in question, when he becomes richer and more prosperous. The income elasticity of demand is greater than unity in the case of comforts and luxuries.

• Income Elasticity of Demand less than unity: In this case, the consumer spends a smaller proportion of his money income on the commodity in question when his income increases. The income elasticity of demand is less than unity in the case of necessaries, the expenditure on which increases in a smaller proportion when the consumer’s money income increases.

Practical significance of income elasticity of demand:• For Demand Forecasting: In developing countries like

India, the incomes of the poor and middle class kept on rising due to economic development. Income elasticity helps producers and businessmen in forecasting demand for non-essential goods like comforts and luxuries,Ey for which is greater than one. These goods are income elastic. Such forecasting enables the private sector to undertake new projects or expand the existing ones, such as production of CTVs, VCRs, cars, superior quality cloth, house construction etc.

• Forward planning of expansion or new ventures can be done by anticipating changes in the income levels of the consumers.

• For taxing income: Luxuries are income elastic. The rich spend lavishly on superfluous or non essential goods. As the income levels increase, the govt collects more from the rich by way of high income tax and higher taxes on luxuries.

• Selection of markets: There are markets patronized by the rich and markets with poor or middleclass consumers. Suppliers and producers supply accordingly different types of goods to such markets; comforts and luxuries to the former type of markets and essential to the latter. Market strategies are thus decided on the basis of income elasticity of demand. Luxuries and comforts are sold in the markets having high income elasticity of demand and essentials in markets with less income elasticity.

Advertising Elasticity of Demand [AED]• Advertising elasticity of demand measures the extent of change in

the quantity demanded of a product to change in expenditure on advertising and other promotional activities.

• AED measures the percentage change in the quantity of a good demanded induced by a given percentage change in spending on advertising in that sector.

• Purpose – To make the demand for a product greater– To make the demand for a product more inelastic

• Good advertising will result in a positive shift in demand for a good. AED is used to measure the effectiveness of this strategy in increasing demand versus its cost.

• AED is usually positive. Negative advertising may, however, result in a negative AED.

Determinants of Advertising elasticity of demand: Advertising elasticity of demand differs between products. Even the same product may not respond in the same manner to different levels of advertising expenditure. Some of the important factors affecting advertising elasticity of demand are

Effect of time: Response to advertisements varies depending upon the type of the product. For ex, durable products take longer time because the consumers will buy new products only when the existing ones becomes unusable or obsolete. The difference in time lag of response for various products varies the advertising elasticity of demand for different products.

Stages of product: The advertising elasticity of demand varies for new as well as old products. It also differs for products with an established and a growing market.

Advertising by competitors: Advertising elasticity of demand also depends upon how a firm’s competitors react to its advertising campaigns. The extent of impact on the advertising and its revenues of a firm will depend on the past and present advertisement campaigns carried by that firm’s competitors.