THEORY OF DEMAND

Concept and Meaning of Demand

Economic analysis is incomplete and meaningless without understanding the concept of demand and
supply. Demand is one of the most important economic decision variables. The analysis of demand for
a firm‘s product plays a crucial role in engineering decision-making. Demand determines the size and
pattern of market. All business activities are mostly demand driven. The demand is the mother of all
economic activities.
A commodity is demanded because it has ability to satisfy want. Demand is that effective desire which
can be satisfied. Effective desire refers to the desire for a commodity plus purchasing power. Thus, the
Demand must satisfy the following characteristics:

i. Desire to acquire a product-willingness to have it,

ii. Ability to pay for it-purchasing power to buy it,
iii. Willingness to spend on it,
iv. Availability of the product at

a) Certain price
b) Certain Place and
c) Certain Period of time
In this way, Demand is an effective desire to obtain certain commodity at certain price, certain Place
and certain Period of time
The complete definition of demand has been given by Prof. Meyers According to him, ―The demand
for a good is a schedule of the amount that buyers would be willing to purchase at all possible prices at
any one instant of time.

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Diverse Concepts of Demand

1. Direct and Derived Demand: Direct demand refers to the demand for goods meant for final
consumption. It is the demand for consumer goods such as sugar, milk, tea, food items etc. On the
contrary to it, Derived demand refers to the demand for those goods which are needed for further
production of a particular good. For instance, the demand for cotton for producing cotton textiles is a case of
derived demand.
2. Perishable and durable goods demand: Perishable goods are also known as non-durable/Single use
goods, while durable goods are also known as non- perishable/ repeated use goods. Bread,
butter, ice-cream etc are the fine example of perishable goods, while mobiles and bikes are the good
examples of durable goods.
3. Autonomous and Induced demand: Autonomous demand for a product is totally independent
of the use of other product, which is rarely found in the present world of dependence. These days we all
consume bundles of commodities. Even then, all direct demands may be loosely called autonomous. The
demand for complementary goods such as bread and butter, pen and ink, tea, sugar milk illustrate the case
of induced demand. In case of induced demand, the demand for a product is dependent on the
demand/purchase of some main product. For instance, the demand for sugar is induced by the demand for tea.
4. Joint demand and Collective/Composite demand: Many times, we use two or more goods together
for satisfying a particular want,the demand for such goods is called as joint demand. The demand for
complementary goods is a fine example. When a commodity is put to several uses, its total demand in all uses
is termed as composite demand. Electricity and water bills are good examples of such a demand.
Composite demand happens when goods or services have more than one use so that an
increase in the demand for one product leads to a fall in supply of the other. E.g. milk
which can be used for cheese, yoghurts, cream, butter and other products.
Example of joint demand- cars and petrol, pens and ink, tea and sugar

5. Individual and Market Demand: The demand of an individual for a product over a period of time is
called as an individual demand, whereas the sum total of demand for a product by all individuals in a
market is known as market/collective demand. This can be illustrated with the help of the following
table:

Determinants of Demand (Factors affecting Demand) / Demand Function

The demand for a particular commodity is influenced by so many factors- they together are known as
determinants of demand in technical jargon, it is stated as demand function. A demand function in
mathematical terms expresses the functional relationship between the demand for a product and its
various determining factors.

DX = f ( Px, Ps, Pc, Yd, T, A, W, C, E, P, G, U)

Here:
Dx = Demand for x commodity (say, tea)
Px = Price of x commodity (of tea)
Ps = Price of substitute of x commodity (coffee)
Pc = Price of complementary goods of x commodity (sugar, milk)
Yd = Disposable income of the consumer
T = Taste and Preference of the consumer
A = Advertisement of x commodity

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W = Wealth of purchaser
C = Climate
E = Price expectation of the consumer
P = Population
G = Govt. policies pertaining to taxes and subsidies
U = Other factors (unspecified/unidentified)

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The Law of Demand
The law of demand states an inverse relationship between the price of a commodity and its
quantity demanded, if other things remaining constant (Ceteris Paribus), i.e., at higher price, less quantity is
demanded and at lower price, larger quantity is demanded.

Assumptions of the law of demand: The law of demand is based on the following important ceteris
paribus assumptions:
• The money income of consumer should remain the same.
• There should be no change in the scale of preference (taste, habit & fashion) of the consumer.
• There should be no change in the price of substitute goods.
• There should be no expectation of price changes of the commodity in near future.
• The commodity under question should not be prestigious or of snob appeal.
Demand Schedule and Demand Curve
Demand schedule is a statistical/tabular statement showing the different quantities of a commodity
which will be bought at its different prices during a specified time period. It is a table which represents
functional relationship between price of a commodity and its quantity demanded. Demand schedule can
be for an individual –known as Individual Demand Schedule (IDS) and it can be for the whole market-
known as Market Demand Schedule (MDS). This is given in the following Table-1
Individual and Market Demand Schedule Table-1

Price of Commodity (Rs.) Units of X Commodity Purchased by Individual Market

A B C (Total)
5 5 10 12 27
6 4 9 8 21
7 3 5 7 15

Demand Curve: By plotting the demand schedule on graph, we can obtain the demand curve. According to
Prof. Samuelson, ―Picturisation of demand schedule is cal ed the demand curve‖. Demand curve
may be linear as well as non-linear depending upon the nature of demand function. Demand curve may
be linear as well as non-linear depending upon the nature of demand function.

Linear Demand curve

Y Non-Linear Demand curve

Price D
(Px)
Price
(Px)
D

O X O
Quantity ( Qx ) Quantity ( Qx

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 Reasons for downward sloping demand curves
As we know that most of the demand curves slope downward to the right because of an inverse
relationship between the price of a commodity and its quantity demanded. But the question is why inverse
relationship exists between the price and quantity demanded. Economists have mentioned the following
reasons of this relationship:
1. Application of the law of diminishing marginal utility: The demand curve is just an extension of
marginal utility curve. According to the law of diminishing marginal utility, a consumer derives less
and less utility from subsequent units of the same commodity. To denote this, the marginal utility curve
slopes downward from left to right. Since the utility derived keeps on diminishing, consumer goes on
reducing the demand. Hence the demand curve slopes downward to the right.
2. Income effect: Another cause behind the operation of law of demand is income effect. As the price of
a commodity falls, the consumer has to buy the same amount of the commodity at less amount of
money. After buying his required quantity he is left with some amount of money.
This constitutes his rise in his real income. This rise in real income is known as income effect. This
increase in real income induces the consumer to buy more of that commodity. Thus income effect is
one of the reasons why a consumer buys more at falling prices.
3. Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other
commodities. The consumer substitutes the commodity whose price has fallen for other commodities
which becomes relatively dearer. For example with the fall in price of tea, coffees. Price being
constant, tea will be substituted for coffee. Therefore the demand for tea will go up.
4. New consumers: When the price of a commodity falls many other consumers who were deprived of
that commodity at the previous price become able to buy it now as the price comes within their reach.
For example the units of colour TV. increases with a remarkable fall in price of it. The opposite will
happen with a rise in prices.
Exception /Limitation to the law of demand
Sometimes, the law of demand may not hold true, although rarely. In such a situation, a consumer
may purchase more at higher price and less at lower price. The followings are few real exceptions to
the law of Demand
1. Giffen goods: Inferior Goods- Some special varieties of inferior goods are termed as Giffen goods. In
case of such goods, the income effect is negative and it is stronger than positive substitution effect.
Examples of such goods are coarse grain like jowar, bajra, coarse cloth and vegetable like potato come
under this category. Sir Robert Giffen studied that people continue to buy more of inferior goods even
at high prices due to lack of substitute products. This is also known as Giffen paradox.people buy more of
these product when the price is high and less when price is low
2. Articles of Distinction/Snob appeal: Luxury goods They satisfy aristocratic desire to preserve
exclusiveness for unique goods- such goods are purchased only by few highly rich people for snob appeal.
For instance, very costly diamonds, rare paintings. These goods are call ed ―veblen goods after
the name of an American economist Thorsten Veblen.
3. Consumers psychological bias or illusion or ignorance about the quality of commodity with price
change. They feel that high priced goods are better quality goods and low price goods are inferior
goods.
4. Essential commodity-The law of demand does not apply in case of life saving essential goods
and also in times of extraordinary circumstances like inflation, deflation, war and other natural
calamities. The law also does not hold true in case of speculative demand. Stock markets are the
fine examples of speculative demand.
5. Bandwagon effect:
This is a very normal occurrence which happens on a regular basis whereby a consumer follows or
imitate the behaviour and consumption pattern of neighbors, relatives and friends. If a certain type of
product is being used by a group then peer pressure encourages members of a group to demand a

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specific product because it is widely used in the group. For instance if Apple's iPhone is used by
majority of the members in a group then the consumer will also demand for iPhone even if the price
rises. It is also known as demonstration effect.
6. Change in fashion:
A change in fashion and tastes affects the market for a commodity. When a broad toe shoe replaces a
narrow toe, no amount of reduction in the price of the latter is sufficient to clear the stocks. Broad toe
on the other hand, will have more customers even though its price may be going up. The law of demand
becomes ineffective.

Changes in Quantity Demanded Versus Changes in Demand

In economic analysis, changes in quantity demanded ‘and‘ changes in demand’ altogether
have different meanings. The changes in quantity demanded relates to the law of demand and it
has reference to extension or contraction‘ of demand, but the changes in demand is related to
increase‘ or decrease‘ in demand.
Changes in quantity demanded take place only in response to the own price of the commodity,
while changes in demand take place due to changes in non-price factors such as income, taste
& preference, price of related goods etc.
In graphical depiction, changes in quantity demanded are shown by the movement along the
same demand curve. A downward movement from one point to another on the same demand
curve implies extension of demand, i.e., more quantity is demanded at lower price. Contrary to
it, upward movement from one point to another on the same demand curve implies contraction
of demand, i.e., less quantity is demanded at higher price.
Changes in demand (increase or decrease), is graphically depicted by shifting of the demand
curve. In case of an increase in demand, the demand curve is shifted to the right and in case of
decrease in demand; the demand curve is shifted to the left.
Increase in demand : Technically, it may be in the following two forms:
 Higher quantity at the same price,
 Same quantity at higher price
Similarly, decrease in demand may also be in following two forms:

 Lesser quantity at the same price.

 Same quantity at lower price.

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 Changes in quantit y dem anded (extension and cont raction of demand)
Y D

P1 B Contraction o f demand

P A

P2 C D Extension o f demand

O Q1 Q Q2 X
Dx

Changes in Demand
Y D Decrease in Demand
Y
D Increase in Demand
1 D2
D
P1 C Px
Px
P A B

P B A

D1
C
D
P
2

O X
Q D2 D
Q1 X
Q2 Q
Dx
O Dx

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ELASTICITY OF DEMAND
Concept of Elasticity of Demand
Law of demand describes the qualitative aspect regarding the inverse relationship between price and
demand and fails to describe quantitative aspects of demand . Law of demand fails to measure how
much‘ of quantity of the product changes due to change in price. Elasticity of demand is the
extension over law of demand which describes the quantitative aspects regarding the inverse
relationship between price & demand.
Definition of Elasticity o f Demand --can be define as ―the degree of responsiveness of
quantity demand of a product to its change in price, other things remaining constant. The concept
of elasticity of demand is generally associated with the name of Alfred Marshal.
In other words, it can be define as ―the Proportionate (percentage) change in quantity
demand of a product to its proportionate (percentage) change in price, other things remaining
constant.‖

Elasticity of Demand(Ed) = Percentage change in Demand ∕ Percentage change in a price of the

Commodity
Types of Elasticity of Demand (Three Types)

1. Price Elasticity of Demand can be define as ―the degree of responsiveness of

quantity demand of a product to its change in price, other things remaining constant.‖ It is
measured as percentage change in quantity demanded divided by the percentage change in price.

Price Elasticity of Demand (Ep) = Percentage change in quantity

Demand
Percentage change in a price
»
Change in quantity Demand ∕ Original Quantity Demand (q) ×
Change in Price 100 Price (P) ×
∕ Original
» 100

2. Income Elasticity of Demand can be define as ―the degree of responsiveness of

quantity demand of a product to its change in income of the consumer, other things
remaining constant.‖ It means the ratio ofpercentage change in quantity demanded due to
percentage change in income of consumers..

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Income Elasticity of Demand (Ey) = Percentage change in quantity Demand
Percentage change in Income of the consumer
»

Change in quantity Demand ∕ Original Quantity Demand (q) × 100

Change in Income ∕ Original Income (y) × 100
»

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 3. Cross Elasticity of Demand can be define as ―the degree of responsiveness of
quantity demand of a product X to its change in price of Product Y, other things remaining

Cross Elasticity of Demand (Exy) = Percentage change in quantity Demand of X

Percentage change in a price of Y
»

Change in Quantity Demand of X ∕ Original Quantity Demand of X (Qx) × 100

Change in Price of Y ∕ Original Price of Y (Py) × 100
»

×
constant.‖

Degree of Price Elasticity of Demand

I.Relatively Elastic Demand(Ep )
It refers to a situation in which percentage change in
demand of commodity is higher than percentage change in
price of that commodity. The demand curve is flatter one.

Figure 1

II. Relatively Inelastic Demand(Ep )

It means when percentage change in demand of a
commodity is less than percentage change in demand in
price. The demand curve is steeper one.
Figure 2
III. Unitary Elastic demand (Ep= )
When equal percentage or a proportionate change in price of
commodity and demand of commodity is there, it is known as
unitary elastic demand. It means that percentage change in
demand of a commodity is equal to percentage change in price.

Figure 3

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 IV. Perfectly Elastic Demand (Ep= )

It is a situation in which demand of a commodity continuously changes without any change in price.
The demand curve is horizontal to OX axis.(figure-4)

I V. Perfectly Inelastic Demand (Ep =0)

When there is no change in demand as a result of change in price then the demand is perfectly
inelastic. The demand curve is vertical on OX axis

Measurem ent of Elasticity of Demand/ Measurement methods

[A] Flux’s Percentage Method/ Mathematical Approach: Prof. Flux tries to measure the price
elasticity of demand with the help of percentage. According to him e= and e=0 does not exist in
practical life and says that e>1, e=1 & e<1 have a practical approach.
According to Prof. Flux ―due to certain percentage change in price of commodity if
certain
percentage change in demand of that particular commodity is there, it is known as price elasticity of
demand.‖ Prof. Flux gives the following formula for the calculation of the price elasticity of demand:

% change in Quantity
EP =
demanded % change in
price
[B] Total outlay method or Revenue method
Total outlay method of measuring elasticity of demand was developed by Marshall. This method tries
to measure change in total expenditure of the consumer or revenue of a firm due to change in the
price of a good.
Total outlay or total revenue is calculated as the multiplication of price and quantity demanded
This method expresses elasticity in three ways:
 Unitary elastic (E=1): Total revenue (outlay) remains unchanged as a result of price change
  Elastic (E>1): Total revenue (outlay) increases with fall in price and vice versa
 Inelastic (E<1): Total revenue (outlay) increases with rise in price and vice versa
This has been explained in the following table.
Price Quantity demandedTotal outlay
(Rs) (units) (price x quantity) Elasticity

10 100 1000
8 150 1200 Elastic (E>1)

10 100 1000
5 200 1000 Unitary(E=1)

10 100 1000
6 150 900 Inelastic(E<1)

[C} Point Method/Geometric Method/Graphical Method

Prof. Marshall devised a geometrical method for measuring elasticity at a point on the demand curve.
Elasticity of demand at any point on the demand curve can be measured as:
Ep = Lower segment of the demand Curve below the given point/ Upper segment of the demand
Curve above the given point
Proof:
Let RS be a straight line demand curve in Figure 11.2. If the price falls from PB(=OA) to MD(=OC).
the quantity demanded increases from OB to OD. Elasticity at point P on the RS demand curve
according to the formula is: Ep = ∆q/∆p x p/q

Where ∆ q represents changes in quantity demanded, ∆p changes in price level while p and q are
initial price and quantity levels.
From Figure 11.2
∆ q = BD = QM
∆p = PQ
p = PB
q = OB
Substituting these values in the elasticity formula:
With the help of the point method, it is easy to point out the elasticity at any point along a demand
curve. Suppose that the straight line demand curve DC in Figure 11.3 is 6 centimetres. Five points L,
M, N, P and Q are taken oh this demand curve. The elasticity of demand at each point can be known
with the help of the above method. Let point N be in the middle of the demand curve. So elasticity of
demand at point.

We arrive at the conclusion that at the mid-point on the demand curve the elasticity of demand is
unity. Moving up the demand curve from the mid-point, elasticity becomes greater. When the
demand curve touches the Y-axis, elasticity is infinity. Moving down the demand curve from the
mid-point, elasticity becomes lesser. when the demand curve touches the X-axis, elasticity becomes
zero.
[D] The Arc Method
We have studied the measurement of elasticity at a point on a demand curve. But when elasticity is
measured between two points on the same demand curve, it is known as arc elasticity. In the words of Prof.
Baumol, ―Arc elasticity is a measure of the average responsiveness to price change exhibited
by a demand curve over some finite stretch of the curve.‖
Any two points on a demand curve make an arc. The area between P and M on the DD curve in
Figure 11.4 is an arc which measures elasticity over a certain range of price and quantities. On any
two points of a demand curve the elasticity coefficients are likely to be different depending upon the
method of computation. Consider the price-quantity combinations P and M as given in Table 11.2.

Table 11.2: Demand Schedule:

Point Price (Rs.) Quantity (Kg)
P 8 10
M 6 12
If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus the point method of measuring elasticity at two points on a demand curve gives different
elasticity coefficients because we used a different base in computing the percentage change in each
case.
To avoid this discrepancy, elasticity for the arc (PM in Figure 11.4) is calculated by taking the
average of the two prices [(p1, + p2 1/2] and the average of the two quantities [(p1, + q2) 1/2]. The
formula for price elasticity of demand at the mid-point (C in Figure 11.4) of the arc on the demand
curve is

On the basis of this formula, we can measure arc elasticity of demand when there is a movement
either from point P to M or from M to P.
From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12
Applying these values, we get

DETERMINANTS/ FACTORS AFFECTINGTHE ELASTICITY OF DEMAND

1. Nature of the Commodity: The commodities satisfying humans wants can be classified broadly
into necessaries on the one hand and comforts and luxuries on the other hand. The nature of
demand for a commodity depends upon this classification. The demand for necessities is inelastic
and for comforts and luxuries it is elastic.
2. Availability of substitutes: The availability of substitutes is a major determinant of the elasticity
of demand. The large the number of substitutes, the higher is the elastic. It means if a commodity
has many substitutes, the demand will be elastic. As against this in the absence of substitutes, the
demand becomes relatively inelastic because the consumers have no other alternative but to buy
the same product irrespective of whether the price rises or falls.
3. Several uses of Commodity: If a commodity can be put to a variety of uses, the demand will be
more elastic. When the price of such commodity rises, its consumption will be restricted only to
more important uses and when the price falls the consumption may be extended to less urgent
uses, e.g. coal electricity, water etc.
4. Range of prices: The demand for very low-priced as well as very high-price commodity is
generally inelastic. When the price is very high, the commodity is consumed only by the rich
people. A rise or fall in the price will not have significant effect in the demand. Similarly, when
the price is so low that the commodity can be brought by all those who wish to buy, a change, i.e.,
a rise or fall in the price, will hardly have any effect on the demand.
5. Proportion of Income Spent: Income of the consumer significantly influences the nature of
demand. If only a small fraction of income is being spent on a particular commodity, say
newspaper, the demand will tend to be inelastic.
Importance of the Concept of Elasticity of Demand:
The concept of elasticity of demand has great practical importance:
For Businessmen and Monopolists:
It guides the businessman in fixing the prices of his goods. If the demand for a commodity is
inelastic, he knows that the people must buy it whatever be the price. In such cases, he will be able to
raise the price. If he is a monopolist he wil certainly do so and earn a larger ne‘ Profit. When the
demand is elastic, a small fall in price will increase the sales and bring more profit.
For the Finance Minister:
The Finance Minister also takes note of elasticity of demand when selecting commodities for
taxation. In case he wants to be certain of the revenue, he taxes those commodities for which the
demand is inelastic. People must continue buying them even though the prices rise with the tax. If the
demand is elastic, people will buy less of them and the Government would get less revenue.
Joint Products:
In case of joint products, separate costs of production of the two commodities are not ascertainable.
In such cases, price of each will depend on the elasticity of demand of each. The transport authorities
also fix the prices of the various services they sell, after considering their elasticity of demand for the
respective services.
In Industrial Production:
The volume of industrial output depends on the nature of demand. If the demand is elastic, by slightly
reducing the price, sales can be increased, and the output too will increase.
Paradox of Poverty in Plenty:
The concept of elasticity can explain how the farmers may remain poor even when there is a bumper
crop. If the elasticity of demand for wheat is unity, the incomes of the growers would remain the
same whatever the condition of the crop. In a year of bad harvest the rise in price would compensate
for reduced output and in a year of good crop, the price will fall and thus reduce the income.
Determination of Wages:
Elasticity can also influence wages. If demand for a particular type of labour is inelastic, it can
succeed in raising wages.

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