HANDOUT 2.

0 | Demand Theory, Analysis and Estimation MANAGERIAL ECONOMICS: MODULE 2

DEMAND THEOY, ANALYSIS AND ESTIMATION

Learning Objectives:
1. Understand the concept of demand, supply, Law of Demand, Law of Supply; the impact of non- price factors to the
level of demand and supply to the market equilibrium;
2. Estimate the level of responsiveness of quantity as caused by changes in price, income, and price of other goods.

Course Content:
1. Demand Theory
2. Factors determining demand
3. Elasticity Demand Estimation

Demand Theory A Demand Table

If necessity is the mother of invention, then demand is the A demand schedule is a tabular presentation of the
mother of production. Demand is the basis of all amount of goods consumers are willing and able to buy at
productive activities. different level of prices over a given period of time.

Demand theory is an economic theory that concerns the A demand curve is the graphical representation of
relationship between the demand for goods and their demand schedule. The demand curve is a downward
prices; it forms the core of microeconomics. sloping curve from left to right. This characteristic of the
demand curve is due to the inverse relationship between
Demand theory is an economic principle relating to the price and quantity demanded.
relationship between consumer demand for goods and
services and their prices in the market. Demand theory
forms the basis for the demand curve, which relates
consumer desire to the amount of goods available.

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 and the Shift in Demand Curve
French-born Gerard Debreu.
Shift in the demand curve is when a determinant of
Concept of Effective Demand demand other than price changes. It occurs when
demand for goods and services changes even though the
The law of demand is normally depicted as an inverse price didn't.
relation of quantity demanded and price: the higher the
price of the product, the less the consumer will demand, To understand this, you must first understand what the
ceteris paribus (all other things being equal). It is an demand curve does. It plots the demand schedule. That
economic theory that the price an individual will pay for a is a chart that details exactly how many units will be
good reflects the sum of the characteristics of that good. bought at each price. It's guided by the law of demand
which says people will buy fewer units as the price
increases. That's as long as nothing else changes, an

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Managerial Economics
Miranda, Arwyn Dela Cruz
HANDOUT 2.0 | Demand Theory, Analysis and Estimation MANAGERIAL ECONOMICS: MODULE 2

economic principle known as ceteris paribus. That means

all determinants of demand other than price must stay the
same.

A shift in the demand curve is the unusual circumstance

when the opposite occurs. Price remains the same but at
least one of the other five determinants change. Those
determinants are:

• Income of the buyers.

• Consumer trends and tastes.
• Expectations of future price, supply, needs, etc. The curve shifts to the right if the determinant causes
• The price of related goods. These can be demand to increase. This means more of the good or
substitutes, such as beef versus chicken. They service are demanded at every price. When the economy
can also be complementary, such as beef and is booming, buyers' incomes will rise. They'll buy more of
Worcestershire sauce. everything, even though the price hasn't changed.
• The number of potential buyers. This determinant
applies to aggregate demand only. Examples

Factors That Cause a Demand Curve to Shift Here are examples of how the five determinants of
demand other than price can shift the demand curve.
When the demand curve shifts, it changes the amount
purchased at every price point. For example, when • Income of the buyers: If you get a raise, you're
incomes rise, people can buy more of everything they more likely to buy more of both steak and
want. In the short-term, the price will remain the same and chicken, even if their prices don't change. That
the quantity sold will increase. shifts the demand curves for both to the right.

The same effect occurs if consumer trends or tastes • Consumer trends: During the mad cow disease
change. If people switch to electric vehicles, they will buy scare, consumers preferred chicken over beef.
less gas even if the price of gas remains the same. Even though the price of beef hadn't changed, the
quantity demanded was lower at every price. That
shifted the demand curve to the left.

• Expectations of future price: When people expect

prices to rise in the future, they will stock up now,
even though the price hasn't even changed. That
shifts the demand curve to the right.

• The price of related goods: If the price of beef

rises, you'll buy more chicken even though its
The curve shifts to the left if the determinant causes price didn't change. The increase in the price of a
demand to drop. That means less of the good or service substitute, beef, shifts the demand curve to the
is demanded at every price. That happens during a right for chicken. The opposite occurs with the
recession when buyers' incomes drop. They will buy less demand for Worcestershire sauce, a
of everything, even though the price is the same. complementary product. Its demand curve will
shift to the left. You are less likely to buy it, even
though the price didn't change, since you have
less beef to put it on.

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Managerial Economics
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HANDOUT 2.0 | Demand Theory, Analysis and Estimation MANAGERIAL ECONOMICS: MODULE 2

• The number of potential buyers: This factor Exceptions to the Law of Demand
affects aggregate demand only. When there's a
flood of new consumers in a market, they will Note that the law of demand holds true in most cases. The
naturally buy more product at the same price. price keeps fluctuating until an equilibrium is created.
That shifts the demand curve to the right. That However, there are some exceptions to the law of
happened when standards were lowered for demand. These include the Giffen goods, Veblen goods,
mortgages in 2005. Suddenly, people who hadn't possible price changes, and essential goods. Let us
been eligible for a home loan could get one with discuss these exceptions in detail.
no money down. More people bought homes until
the demand outpaced supply. At that point, prices Giffen Goods
rose in response to the shift in the demand curve.
Giffen Goods is a concept that was introduced by Sir
Aggregate demand is a measurement of the total Robert Giffen. These goods are goods that are inferior in
amount of demand for all finished goods and comparison to luxury goods. However, the unique
services produced in an economy. Aggregate characteristic of Giffen goods is that as its price increases,
demand is commonly expressed as the total the demand also increases. And this feature is what
amount of money exchanged for those goods and makes it an exception to the law of demand.
services at a specific price level and point in time.
The Irish Potato Famine is a classic example of the Giffen
Aggregate demand is a macroeconomic term and goods concept. Potato is a staple in the Irish diet. During
can be compared with the gross domestic product the potato famine, when the price of potatoes increased,
(GDP). GDP represents the total amount of people spent less on luxury foods such as meat and
goods and services produced in an economy bought more potatoes to stick to their diet. So as the price
while aggregate demand is the demand or desire of potatoes increased, so did the demand, which is a
for those goods. Aggregate demand and GDP complete reversal of the law of demand.
commonly increase or decrease together.
A Giffen good, a concept commonly used in economics,
Key Takeaways refers to a good that people consume more as the price
rises. Therefore, a Giffen good shows an upward-sloping
• When there is movement only along the demand demand curve and violates the fundamental law of
curve, this means price is the only factor that is demand.
changing.
• When the entire demand curve shifts, it signals Veblen Goods
that other determinants of demand, excluding
price, have changed. The second exception to the law of demand is the concept
• Aside from price, other determinants of demand of Veblen goods. Veblen Goods is a concept that is
that affect the demand schedule or chart are named after the economist Thorstein Veblen, who
income, consumer tastes, expectations, price of introduced the theory of “conspicuous consumption“.
related goods, and number of buyers. According to Veblen, there are certain goods that become
• Shift of the demand curve to the right indicates an more valuable as their price increases. If a product is
increase in demand at whatever price because a expensive, then its value and utility are perceived to be
factor, such as consumer trend or taste, has risen more, and hence the demand for that product increases.
for it. Conversely, a shift to the left displays a And this happens mostly with precious metals and stones
decrease in demand at whatever price because such as gold and diamonds and luxury cars such as Rolls-
another factor, such as number of buyers, has Royce. As the price of these goods increases, their
slumped. demand also increases because these products then
become a status symbol.

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Managerial Economics
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HANDOUT 2.0 | Demand Theory, Analysis and Estimation MANAGERIAL ECONOMICS: MODULE 2

The expectation of Price Change product, which is not always the case. Therefore, when
the price of a product falls, the demand for that product
In addition to Giffen and Veblen goods, another exception automatically decreases.
to the law of demand is the expectation of price change.
There are times when the price of a product increases and Brand Loyalty
market conditions are such that the product may get more
expensive. In such cases, consumers may buy more of This is also considered as an exception to the law of
these products before the price increases any further. demand refers to a consumer’s preference for a particular
Consequently, when the price drops or may be expected brand. Most of the consumers are very sticky with the
to drop further, consumers might postpone the purchase brands which they used in daily life and very hardly switch
to avail the benefits of a lower price. the brand. They buy the products of that brand regardless
of the change in price. For instance, let a consumer
For instance, in recent times, the price of onions had prefers Levi’s jeans, he will continue to buy them
increased to quite an extent. Consumers started buying regardless of the price increase. In this scenario, the
and storing more onions fearing further price rise, which application of the law of demand will be considered as
resulted in increased demand. void.

There are also times when consumers may buy and store Speculation
commodities due to a fear of shortage. Therefore, even if
the price of a product increases, its associated demand Another execption to the law of demand is about
may also increase as the product may be taken off the speculation plays a vital role in neglecting the demand
shelf or it might cease to exist in the market. theory. Speculation means the assumptions which a
rationale consumer makes for future developments by
Necessary Goods and Services keeping in view the particular product.

Another exception to the law of demand is necessary or In this case, if a consumer makes an assumption that the
basic goods. People will continue to buy necessities such price of a particular product will increase in the future then
as medicines or basic staples such as sugar or salt even he buys more of it regardless of price in the current
if the price increases. The prices of these products do not situation. However, this violates the law of demand.
affect their associated demand.
Emergency Situations
Change in Income
The last exception to the law of demand is about
Sometimes the demand for a product may change emergency conditions such as earthquakes, floods,
according to the change in income. If a household’s scarcity, famine, war or any untoward situations
income increases, they may purchase more products consumers are not thinking about the change in price and
irrespective of the increase in their price, thereby buy the products regardless of price variations and tried
increasing the demand for the product. Similarly, they to store as much as products. Therefore, in such
might postpone buying a product even if its price reduces situations, the law of demand is not applicable.
if their income has reduced. Hence, change in a
consumer’s income pattern may also be an exception to *End of Module 2*
the law of demand.

Psychologically Bias Customers:

Please note that this important exception to the law of

demand. Different customers have different ideas/views
about the price of a product. Some customers feel that the “Love yourself, and love those
low price is synonymous with poor quality of a particular who truly love and value you.”

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Managerial Economics
Miranda, Arwyn Dela Cruz