MODULE 2

DEMAND THEORY

According to Prof. Hibdon “demand means the various quantities of goods that would be purchased
per time period at different prices in a given market.”
To constitute demand for a product the following three conditions should be fulfilled

a) There should be a desire to acquire the product.

b) The person desirous of acquiring the product should have the ability to Pay for it.
c) The person should also have the willingness to pay for the product.

Law of demand

Price is one of the important factors that influences demand for a commodity. More of a commodity
will be demanded at a lower price and less of it at a higher price/ “The law of demand states that there
is a negative (or inverse) relationship between the price of a good and the quantity demanded, holding
other factors constant (Cetris paribus).

Assumptions of the Law of demand

The law of demand is based on the following assumptions

1) The income of buyers should remain constant. It means that there should not be any change
in the income of buyers.
2) The tastes, habit and preferences of the buyers do not change.
3) There should not be any change in the prices of related goods- substitute goods and
complementary goods
4) The buyers should not anticipate any change in the price of goods.
5) There should not be any change in the number of buyers in the market.
6) The buyers should not anticipate any shortage in the supply of a particular commodity.

Demand schedule

Demand schedule is a tabular statement of consumers intention to purchase a particular commodity

at different prices.

Price of rice in rupees per kg Quantity demanded per

month (in Kg)
25 5
20 10
15 20
10 35
5 55

Demand Curve

Demand curve is a graphical presentation of the inverse relationship between price and quantity
demanded. When the demand schedule is presented in the form of a graph we obtain the demand
curve. The demand curve can be either linear or non linear.
Reasons for the Law of Demand
(Why does the demand curve slope downward?)
The inverse relationship between price and quantity demanded is due
To the following reasons.
1. Income effect
Whenever there is a fall in the price, a consumer needs to pay less for the same quantity of
goods as he was purchasing before. This will increase his purchasing power and will have an
increasing effect on his income in real terms.
2. Substitution effect
Substitution effect is another reason for the downward slope of demand curve. When the
price of a commodity increases there is a natural tendency among customers to substitute
more costly products with less costly products. This tendency of substitution has a positive
effect on the quantity demanded of a product whose price is relatively lower and negative
effect on the product whose price is relatively higher.
For example tea and coffee are substitutes and if the price of coffee increases, some customers will
shift their consumption from coffee to tea and therefore the demand for tea increases and the
demand for coffee declines.
3. Law of diminishing marginal utility
Demand curve slopes downward because of the operation of law of diminishing marginal
utility. As the marginal utility derived from the consumption of more and more units of the
same commodity goes on diminishing, a consumer will be ready to buy more of it only if it is
available at a lower price.
 4. Change in the number of buyers
A fall in the price of a commodity will attract new buyers who could not buy it before on
account of high prices. This will increase demand of a commodity whose price has fallen.
Similarly some of the existing buyers will find it unaffordable to buy a product if its price rises
and the quantity demanded of it diminishes.
5. Various uses of a commodity
The inverse price demand relationship will be more in the case of a commodity which can be
put to various uses. It will be put to more urgent needs only if there is an increase in its price.
If there is a decline in price it will be put to less urgent needs as well. Therefore quantity
demanded decreases with a rise in price and increases with a fall in price. E.g. use of y
electricity
Exceptions (Limitations) to the Law of Demand
There are certain situations where the inverse price quantity relationship will not hold good. These
situations are referred to as exceptions to the law of demand. In these cases the demand curve will
rise upward showing positive price quantity relationship. These cases are discussed below.
1) Inferior goods or Giffen goods
The concept of Giffen goods was discovered by Sir Robert Giffen. Giffen goods are inferior goods that
have no substitutes and are mostly consumed by low income group and a significant portion of their
income is spent for these goods. Sir Robert Giffen observed that the low paid British workers
consumed more bread even when the price of bread was rising in England in the 19 th century. This
was so because bread was still the cheapest as compared to the prices of meat, egg and butter. The
staple food of the British workers was bread. This situation of increase in demand during times of
increase in prices of bread was referred to as Giffen paradox.
2) Prestige goods
Another exception to the law of demand is associated with the name of an American economist,
Thorstein Veblen. According to him some of the customers measure the utility of a product by its price.
For them higher the price of a commodity, higher is the utility and vice versa
3) Consumer expectations
The price quantity relationship will become positive depending on the expectations of consumers.
Consumers will demand more of a commodity even when its price is rising whenever a serious
shortage is expected. Similarly consumers will postpone their purchases in a situation of falling prices
when they expect a further fall in its price. This is contrary to the law of demand.
4) Consumer’s misconceptions
There are snobbish buyers in the market who consider that higher the price higher will be the quality
and vice versa. In the case of these buyers they demand more at a higher price and less at a lower
price.
5) Change in fashion
If a product becomes out of fashion, consumers will refuse to buy it even if there is a reduction in
price. They will prefer to buy even at a higher price those goods which are latest in fashion..

Methods of Forecasting

The methods or techniques of demand forecasting are broadly divided into three as;
1. Survey methods
2. Market experimental methods
3. Statistical methods

1. Survey methods
 Under survey method surveys are conducted to collect data relating to future demand of a
product. The data is collected either directly from the customers or from retailers, salesmen
and other sales experts who are in close contact with the customers. Survey method is quite
useful for short term demand forecasting of consumer goods. On the basis of the source from
which data is collected they are divided into (a) Direct interview method (b) Expert opinion
method.
(a) Direct interview method
Under this method data relating to future demand of a product is directly collected from customers.
Data is collected either by conducting consumer interviews or sending them mailed questionnaire.
In a survey, questions about consumer reactions to a proposed changes in price, changes in their
income, advertisement expenditure etc.
There are two ways of conducting a survey. It may be either complete enumeration survey or sample
survey. In complete enumeration survey all customers of a product are asked questions about the
quantity of a product they plan to buy in future. This is possible in the case of products having limited
number of customers.

If the number of customers are large, sample survey method is adopted. Under this method only a
specified number of customers are selected as sample customers and data is collected from them
only.
Limitations.
a. Personal bias of the investigator then the result would be misleading.
b. There may be response bias
c. The consumers may not be able to give an accurate answer to a hypothetical question
d. Survey methods are time consuming and costly.

(b) Expert opinion method

Under this method demand forecasting is done by collecting opinions of experts. The
experts may be salesmen, retailers or outside professionals.
There are various methods of collecting expert’s opinion about future demand. One
such method is Delphi technique.

Delphi Technique or Delphi Method

Under this method, opinions about the future demand of a product are collected
separately from a panel of experts. Then each expert is told about the prediction of
other experts without revealing the identity of each other. Each one is then asked to
revise his prediction in the light of others opinions. The experts are again shown each
other’s revised forecasts and asked to reconsider their forecasts in the context of
other’s revised forecasts. This process continues till a common consensus is arrived.
2. Market experimental methods

In these methods, the reactions of customers are studied under different market
experiments conducted either in the actual market or in a simulated (artificial)
market. Market experimental methods are useful when a firm makes changes in price,
advertisement expenditure or when a new product is introduced. Generally there are
two types of market experiments (a) Test marketing (b) controlled experiments.

(a) Test Marketing

Test marketing is a market experimental method used in the case of new products.
An area which represents the whole market is selected as the test area and the
product is introduced in this area for observing the customer’s reactions. By
 introducing the product in more than one test a firm can judge the effect on demand
to changes in price, advertising packaging, product model etc.

(b) Controlled experiments (consumer clinics)

Under this method, a sample of customers representing a target market is asked to
visit a shopping centre where different brands of a particular product are displayed
for sale. They are now asked to state how much of each brand they would buy at
various prices. Their responses are recorded and they are given advertising materials
of various brands.

3. Statistical methods

Statistical methods are useful for those products for which past data over a number
of years are available. The following are the important statistical methods used for
demand forecasting.

(a) Trend projection method

This method makes use of past sales data of a particular product. When the sales
figure of previous years is arranged in a chronological order they become a time
series. This time series gives the past sales trend and the trend when extrapolated
into the future gives the future sales.
(b) Correlation and regression analysis

There is correlation between two variables when both of them vary in such a way that
the variations in one variable are accompanied by variations in another variable.
(c) Econometric method

Econometric method is a blend of economic theory, mathematics and statistics. Under

this method, on the basis of economic theory a mathematical equation describing the
relationship between economic variables is established. Then through the use of
statistical methods estimates of parameters of the equation are made. Then on the
basis of these parameters demand forecasting is done.

Demand Determinants
The demand for a product depends upon many factors. These factors are called determinants of
demand. They are explained below.
1. Price of the product
Price is the most important factor that determines the demand of commodity. As per the law of
demand, a commodity will find more demand if its price is low and less demand if its price is high.
2. Consumer income
The demand is influenced by the consumer income. Whenever there is an increase in consumer
income their purchasing power increases and they can afford to buy more. They will also spend more
on quality goods and less on inferior goods. Therefore the demand for inferior goods falls and quality
goods rise with an increase in consumer income. Similarly a decline in consumer income negatively
affects demand for quality goods and positively affects demand for inferior goods.
3. The price of related goods
Goods can be related to each other either as substitutes or complements. Two products are regarded
as substitutes when the demand for one product rises with the rise in price of other product. In other
words, the demand for one product falls with a fall in the price of another product. For example tea
and coffee are substitute goods. If the price of tea increases, the demand for coffee increases because
some of the consumers will shift their consumption from tea to coffee.

Two products are said to be complements when the demand for one falls with the rise in price of
another or vice versa. Examples of complementary goods are car and petrol, milk and sugar, electricity
and air conditioner etc.
4. Amount spend on advertisement
The demand for a product is greatly influenced by the amount spends on advertisement. Repeated
and attractive advertisements will certainly prompt customers to buy a product. Therefore more is
the amount spend on advertisement, more will be the demand.
5. Consumer preferences
Consumer preferences depend upon many factors like fashion, habit customs and traditions, beliefs,
advertisement etc. Whenever there is any change in any of these factors their preference for a
particular product al changes and it affects its demand.
6. Consumer expectations
Consumer expectations regarding the likely change in price of commodity influence the demand
condition. The mere expectation of a increase in a product’s price can induce people to buy more of
it. Similarly they will postpone their purchases when they expect a fall in it’s price.
7. Number of buyers in a market
If there is an increase in the number of buyers in a market , the demand will increase. The number of
buyers in a market may increase due to relaxed immigration barriers or migration of people from one
region to another etc.
8. Money supply
The demand situation in a country depends on the money supply in economy. Central bank of a
country increases the supply of money during times of economic depression and decreases the supply
of money during times of economic prosperity. The supply of money and demand an positively related.
An increase in money supply will increase demand and vice versa.
9. Taxation policy
Taxation policies of the government of a country with regard to direct and indirect taxes will affect
the demand for goods. An increase in income tax will reduce purchasing power and will adversely
affect the demand. A increase in indirect taxes like sales tax, excise and customs duties will cause an
increase in the price and it will negatively influence the demand.
10. Seasonal goods
The demand for seasonal goods such as woollen clothes, umbrella, ice cream and soft drinks are
affected by climatic conditions. During seasons they are demanded more and during off seasons they
are demanded less.

Movements Vs. Shift in Demand

It is important to make a distinction between movement along a demand curve and a shift of the
whole demand curve. Movement along the demand curve indicates changes in the quantity
demanded as a result of price changes, other factors affecting demand remaining con But a shift of
the demand curve indicates that there is a change in demand at each possible price as a result of
changes in other factors affecting demand such as income, taste or price of related products.

Movements in Demand (Expansion or Extension and Contraction of Demand)

The demand of a commodity is determined by many factors including the price. Price plays a significant
role in determining demand. Whenever there is a change in quantity demanded as a result of a change
in price, expansion and contraction of demand takes place.
When there is an increase in quantity demanded as a result of a fall in price, expansion of demand is
said to have taken place. On the contrary, contraction of demand takes place whenever quantity
demanded decreases as a result of a rise in price.

Shift in Demand (Changes in Demand)

When demand changes as a result of a change in factors other than price, it is called shift in demand.
Shift in demand is caused by factors like changes in consumer’s income, their tastes and preferences,
price of related goods etc. Here the change is only on factors other than price and price is held
constant.

A shift in demand can be either a rightward shift or a leftward shift. A rightward shift of the demand
curve implies that more quantities are demanded at a price which remains constant. It signifies
increase in demand. A leftward shift of the demand curve implies that less quantity are demanded
and it signifies decrease in demand.

Characteristics (Essentials) of a Good Forecasting Method

1. It should be accurate

A good forecasting method should give accurate results. It means that the forecasted demand should
be more or less equal to the actual demand.

2. It should be simple and understandable

It means that the method should not involve complex procedure and calculations.

3. It should be economical

A good forecasting method should be economical in the sense that the cost incurred in demand
forecasting should be less than the benefit involved in such forecasts.

4. It should not be time consuming

The procedures and calculations involved in demand forecasting should not be too much time
consuming.

5. It should be long lasting

A good forecasting method is such that it gives reasonable results which can be used for a long period.

6. It should be flexible

The demand conditions are subject to frequent changes and therefore a good forecasting method
should be flexible enough to adapt to the changed market conditions.

Limitations of Demand Forecasting

1. Chances of errors
Demand forecasting is a study of human behaviour and therefore it cannot be hundred percent
accurate.

2. Inexactness in predicting the future

Future is always uncertain and therefore future cannot be predicted with precision.

3. Time consuming

Good forecasts of demand cannot be completed over night. It takes time.

Hurry it may lead to misleading results.

4. Lack of competent personnel

The effectiveness of demand forecasting depends on the quality of staff involved in the process.

5. Cost consideration

It requires large amount of money to undertake demand forecasting especially when survey method
is used. Small business firms may not be able to afford the cost of demand forecasting.

Factors influencing price elasticity of demand

The degree of responsiveness of demand to a change in the price of a product depends on various
factors as discussed below.
1. Availability of substitutes
The elasticity of a product is greatly influenced by the availability of substitutes. If a product
has a wide variety of substitute products available in the market, its demand tends to be more
elastic. On the other hand, the demand tends to be inelastic if a product has no close
substitutes.
1. Nature of the product
Elasticity of demand depends upon whether the product is a necessary item or luxury item. In
the case of necessary items like rice, salt, sugar etc. Demand is inelastic while the demand for
luxury goods is elastic
2. The number of uses of a commodity
The demand of a commodity which can be put to various uses has an elastic demand. Its
demand will go up when it becomes cheaper and its demand will come down when it becomes
costlier. For example electricity, Coal, milk etc. If a product has only limited use its demand
will be inelastic.
3. Proportion of total expenditure
Another factor that determines the elasticity of demand of a commodity is the proportion of
a consumer’s income spend on that commodity. If a consumer spends a higher portion of his
income on a particular commodity it will have an elastic demand, example, demand for
clothing. On the contrary if a small portion of income is spent on a product its demand will be
inelastic, example, demand for salt, match box, candles etc.
4. Urgency of use
Those commodities the use of which can be postponed have an elastic demand. For example
if the price of cement, bricks, sand etc. Goes up people will postpone construction of buildings.
The demand will be inelastic in the case of those products that need to be consumed urgently.
For e.g. medicines.
 5. Complementary goods
If two goods are complementary goods, the elasticity of demand of one product depends up
on the elasticity of demand of another product. For example if the demand for automobiles is
elastic, the demand of automobile spare parts will also be elastic.
6. Level of prices
There will be inelastic demand in the case of high priced and low priced products. As high
priced products are used by people with higher incomes, any change in their prices will not
significantly affect them. Similarly people will continue to demand the same quantity of low
priced products even if there is a change in their price. Medium priced products have generally
elastic demand.
7. Time factor
The elasticity of demand of a product varies with the time available to consumers to make
adjustments in their scheme of consumption. Longer the time available greater is the elasticity
of demand and shorter the time available lesser is the elasticity of demand.
8. Consumer’s habit
The elasticity of a product is greatly influenced by consumer’s habit If consumers are
habituated to the consumption of a particular product its demand is inelastic. For example,
cigarettes, alcohol, soft drinks etc. Further, if consumers become more brand loyal to a
particular brand, its demand will also be inelastic.
9. Life of a product
The demand will be elastic in the case of products that can be used for a longer period.
Television, refrigerator, electric fans etc. Belong to this category. If the price of these products
increases, people will continue to use the old ones by spending more amounts on repairing
charges.

Important classifications of the concept of elasticity of demand.

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertising elasticity of demand

Price Elasticity of Demand (ep)

Price is an important determinant of demand for a product. Price elasticity of demand refers to the
degree of responsiveness of consumers to a change in price of a product. Consumer’s response to
changes in price will be in terms of the changes in quantity demanded. In other words, price elasticity
of demand is the ratio of the percentage change in quantity demanded to a percentage change in
price. Therefore,

Ep= percentage change in quantity demanded ÷ percentage change in price

Degrees of Price Elasticity of Demand

A small change in price may result in a large change in demand or a large change in price may result
in a small change in demand. The demand in the former case is said to be elastic and the demand in
the latter case is said to be inelastic. There are five cases of elasticity based on the degree with which
demand responds to price.
 1. Perfectly elastic demand (infinite elasticity)

Demand is said to be perfectly elastic when a very small change in price results in an unlimited change
in demand.

2. Perfectly inelastic Demand (Zero elasticity)

Demand is said to be inelastic when demand is unaffected by changes in price. It means that the
quantity demanded does not respond to a rise or fall in price.

3. Relatively elastic demand

Demand is said to be relatively elastic when a change in price results in a more than proportionate
change in demand. In this case the percentage change in quantity demanded is more than the
percentage change in price and therefore the elasticity of demand is greater than one.

4. Relatively inelastic demand

Demand is said to be relatively inelastic when a change in price results in a less than proportionate
change in demand. In this case the percentage change in quantity demanded is less than the
percentage change in price and therefore the elasticity of demand is less than one.

5. Unit elasticity

Demand is said to be unitary elastic when a change in price results in an equal and proportionate
change in demand. In this case the percentage change in quantity demanded is equal to the
percentage change in price and therefore the elasticity of demand is equal to one.

Forecasting demand for new products

1. Evolutionary approach

According to this approach the demand for the new product is considered as an extension of the
demand of an existing product. Here the new product is an improved version of the existing product.

2. Substitute approach

This approach of demand forecasting may be used for products that have close substitutes available
in the market. As per this approach the demand for the new product is forecasted on the basis of the
demand for the substitute products.

3. Growth curve approach

Under this approach the demand of a new product is forecasted on the basis of the growth trend of
all similar existing products taken together.

4. Opinion poll approach

The estimation of demand of a new product under this approach is based on the opinions collected
either from a sample of customers or from all the customers.

5. Sales experience approach

Here the product is sold in a sample market which should be a true representative of the whole
market. On the basis of the customer’s reactions to the new product in the sample market, the
demand is estimated.

6. Vicarious approach

Under this method the responses of the customers to a new product are analysed indirectly through
the dealers.

Managerial uses of price elasticity of demand

(Practical applications or importance)

1. Determining selling price

Price elasticity of demand is an important tool in the hands of a producer to arrive at the selling price
of his product. A high price can be fixed for a product with inelastic demand and a lower price for a
product with elastic demand. So it is essential that the price elasticity of demand should be known
before fixing the selling price.

2. To practice price discrimination

Price discrimination is the practice of charging different prices for the same product from different
market segments. If there are sub-markets existing within a market and if the elasticities differ from
market to market, price discrimination can be resorted to. A high price can be charged in a market
where there is inelastic demand and a lower price in an elastic market.

3. Helps the government

The concept of price elasticity of demand helps the government to decide about the indirect tax rates
such as sales tax, excise and customs duties etc. To be charged on various products. A high tax rate
can be charged on products that have inelastic demand while a low tax rate on products with elastic
demand.

4. Pricing of joint products

Joint products undergo common production process up to a particular stage. In the case of these
products it becomes difficult for a producer to exactly divide the joint cost among the products. In
such a situation producers can apply the concept of price elasticity of demand for fixing the price of
joint products. A product with inelastic demand can be priced high and the one with elastic demand
can be priced low.

5. International trade
Trade between two countries is called international trade A country exports goods to other countries
and also imports goods from others. The difference between export and import is called balance of
trade. The balance of trade can be made favourable to some extent, if a country exports goods with
inelastic demand and import goods with elastic demand

6. Controlling business cycle

There will be ups and downs in the economy like boom and depression During economic depression
production and consumption are low. During depression the government of country has to implement
stimulus package in the form of reduction of indirect taxes to stimulate consumption and production.
It will be more effective if the government reduces tax rates of those products whose demand is more
elastic because a fall in the price of these goods will enhance more consumption.

7. Economies of large scale production

If a producer wants to take full advantage of the economies of large scale production he can do so in
case his product’s demand is elastic. Because he can sell more quantities if he lowers the price of his
product.

Income elasticity of demand

Income elasticity of demand measures the degree of responsiveness of demand for a commodity to a
change in consumer’s income. In other words, income elasticity of demand is the ratio of the
percentage change in quantity demanded of a product to a percentage change in income of a
consumer.

Types income elasticity

Zero income elasticity

Change in income causes no change in consumers quantity demanded.

Positive income elasticity

Increase in income of the consumer leads to increase in quantity demanded.

Negative income elasticity

Increase in income leads to a decrease in quantity demanded.

Cross elasticity of demand

Cross elasticity of demand indicates the relationship between the demand of one product with the
price of another product. It may be defined as the degree of responsiveness of demand for one
product in response to a change in the price of another product.

Advertisement elasticity

Advertisement elasticity of demand measures relationship between the demand of a product with the
amount spend on its advertisement. It is also called promotional elasticity of demand. Advertisement
elasticity of demand may be defined as the degree of responsiveness of demand of a product in
response to a change in the amount spend on its advertisement.