M3 DEMAND THEORY

Meaning and Definition of Demand

Demand is the desire for a commodity backed by willingness and ability to pay for it. It
refers to the number of units of a commodity, that the customers are prepared to
buy at a price during a particular period from a given market.

Demand for a Commodity

Demand for a commodity refers to the quantity of a commodity demanded in the market
in a given period of time at a given price. Generally, at a lower price more will be
demanded and at a higher price less will be demanded.

Utility

The term utility refers to the 'want satisfying capacity' of a commodity or a service.

Law of Demand

The law of demand states that, other things being equal, the quantity demanded for a
commodity varies inversely with its price. That is, when price rises, demand for the
commodity falls and when price falls, demand for the commodity rises.

Assumptions of the Law

i. Income remains constant: It is the most important assumption of the law of

demand. As per this assumption, inorder to operate this law, the income of the
consumer must remain constant or should not change. Income is assumed to remain
constant, as its rise may induce the consumer to buy more goods leading to rise in
demand and price.

ii. No change in prices of related goods: The assumption is that the prices of
related goods (complementary and substitute goods) do not change and remain the
same.
iii. No change in consumer's taste and preferences: The law of demand
considers that the taste, preference, habit, custom, etc. of the consumer should remain
unchanged.

iv. No change in price in future: Next assumption of law of demand to remain valid
is not to expect any future possibilities regarding a change or fluctuation in the prices of
commodities.

v. No change in the climatic condition: The law of demand assumes that the
weather condition or climate of a region or geographical area should remain the same.

vi. No change in size and composition of the population: The law assumes that
the size and composition of the total population of a country should not change.

Demand Determinants (Determinants of Demand)

The demand for a product is influenced by many factors. These factors are known as
"determinants of demand”.

1. Price of the product: Price has a dominant role in shaping the demand for a
product. The law of demand justifies it by proving that there is an inverse relationship
between the price and the quantity demanded. A fall in price of a commodity
encourages more consumption by the existing customers and also brings in new
customers, while an increase in the price of a commodity may induce the existing
customers to go for substitutes.
2. Income of the consumer: Purchasing power of the consumer depends upon his
income. It is the income that decides the type and quantity of the goods to be
purchased. When the income of a person rises he may go for quality goods. On the
other hand if the income falls, he may buy inferior goods.

3. Price of related goods: Related goods are substitute goods and complementary
goods. Tea and coffee, rice and wheat, fish and meat etc., are examples of substitute
goods. When the price of a commodity increases, the demand for its substitute
commodity goes up. Complementary goods are those which are jointly used. For
example, coffee and sugar, bread and butter, pen and ink, car and petrol etc. In the
case of complementary goods, increase in the price of one commodity reduces the
demand for the other

4. Advertisement Effect: Advertisement has a major role in influencing demand.

Advertisement attracts new customers to the product in addition to encouraging more
consumption by the existing customers.

5. Demonstration effect: It refers to change in the demand for the products due to
change in the consumption habit of the consumers. In other words, people may try to
imitate the consumption pattern of their rich neighbours. Similarly, there is a tendency
on the part of the people of developing countries to imitate the consumption pattern of
the people of developed countries. Eg. demand for tinned and fast foods. This infact,
becomes an important factor influencing demand.

6. Tastes and preferences of the consumers: Fashion, habit and customs create
tastes and preferences for the product. Advertisements help to change and shape the
tastes and preferences of the customers for the product.

7. Expectations of the consumers: When the consumers expect changes in

future supply and price, they will alter their current demand for the product. The
anticipated price cut reduces the current demand and the anticipated short-fall in
production will boost the current demand even if the price goes up slightly.

8. Population: The demand for the products will be more in a country with vast
population when compared to a sparsely populated country. Nature and composition of
the population also affect the demand. A country with more female population offers
greater demand for the products solely meant for the use of females. A population with
high percentage of children is a good market for baby food and other products meant for
babies.

9. Weather: Certain articles like woolen clothes and umbrella, are for seasonal use.
They are used according to weather conditions.

10. Change in the volume of money in circulation : When the money-circulation in

the society increases, the purchasing power of the people also increases. This will
result in a general increase in demand Likewise, a reduction in money supply reduces
demand.

11. Consumer Credit Facility: If the consumers can get credit facility from the
sellers, banks etc. they will buy more. Credit facility mostly affects the demand of costly
durable goods.

12. Government policy: The policy of Government with regard to taxes and subsidy
also affects demand as it has some effects on the price of the products and purchasing
power of the people. Income tax and other direct taxes increase their prices and
therefore in both the cases demand decreases. On the contrary, when the Government
grants subsidy on certain articles, their prices fall and demand increases.
ELASTICITY OF DEMAND

The law of demand states that the demand of a commodity increases on a fall in its
price and decreases on an increase in its price. The concept of elasticity of demand has
been introduced by Marshall to measure the change in demand.
In physics, elasticity means the expansion and contraction of an object as force is
applied and released. In economics, the term elasticity means the rate of change in one
variable in response to the change in another variable.
“Price Elasticity of demand is a measure of the responsiveness of quantity
demanded to a change in price”.
In short, elasticity is the rate of change in the quantity demanded due to a change
in price.

1. Price elasticity

This is the most important and most popular elasticity. It measures the responsiveness
of demand to change in price. It is measured by using the following formula:

Proportionate change∈Quantity demanded

ED =
Proportionate change∈ Price

Degree of Price Elasticity of Demand

Some commodities have very elastic demand. Others have less elastic demand. Thus,
different commodities have different degrees of elasticity. The following are the various
degrees of elasticity (price elasticity):
1. Perfectly elastic demand: When a small change in price leads to a great
change in demand, it is known as perfectly elastic demand. Even when the price
remains the same, the demand goes on changing. The demand curve will be a
horizontal straight line. This is only an imaginary demand curve because in real life
there is no commodity having perfectly elastic demand.

Quantity Demanded

In the diagram at Price OD, the quantity demanded is OQ. Here at the same price,
demand increases to OQ2, and decreases to OQ1, This situation is called perfectly
elastic demand. The shape of the demand curve (DD) is horizontal straight line.

2. Perfectly inelastic demand: When a demand of a commodity doesn't change,

whatever be the change in price, it is called perfectly inelastic demand. In this case a
great change in price leads to no change in the demand. Here the demand curve will be
vertical. This is also an imaginary demand curve because in real life there can be no
such commodity with such demand.
In the diagram at OP price, the quantity demanded is OD. Here the demand of the
commodity remains constant at all price levels. Demand doesn't change even when the
price increases to OP1, or decreases to OP2. This situation is called perfectly inelastic
demand. The shape of the demand curve (DD) is vertical.

3. Unit elasticity (Unitary elasticity):

When a given percentage change in price causes an equally proportionate change in
demand, it is called unit elasticity. For example, if 5% increase in price of a commodity
brings about a 5% fall in demand, it is a case of unit elasticity. Here the elasticity is one
In the given diagram at OP price, Quantity demanded is OQ. If the price increases to
OP1, demand decreases to OQ1. Here the increase in price and decrease in demand
are in equal proportion (DP1 = DQ1). Similarly, if the price decreases to OP 2, the
demand increases to OQ2. Here also the decrease in price and increase in demand are
in equal proportion (OP2 = OQ2).

4. Relatively elastic demand:

When change in price results in a more than proportionate change in quantity

demanded, it is called relatively elastic demand. For example, if 5% increase in price
brings about a 10% fall in demand, the demand is said to be relatively elastic or very
elastic.

In the diagram , the quantity demanded is OQ. If price increases by PP 1, demand

decreases by QQ1 Here the decrease in demand is more than proportional increase in
price (DQ1 > DP1). Similarly, if price decreases by PP2, the demand increases by QQ2.
Here the increase in demand is more than proportionate fall in the price (DQ 2 > DP2).
This is the case of relatively elastic or highly elastic demand. In this case the shape of
the demand curve is flat or semi-horizontal.

5. Relatively inelastic demand:

When change in price results in less than proportionate change in quantity demanded, it
is called relatively inelastic demand. For example, 10% increase in price brings about
5% decrease in demand, the demand is relatively inelastic. Arithmetically it is known as
less than unit elastic demand (e = < 1).

In the given diagram at OP price, the quantity demanded is OQ. If price increases by
PP1 the demand decreases by QQ1. Here decrease in demand is less than
proportionate increase in price (DQ1 < DP1). Similarly, if price decreases by PP 2 the
demand increases by QQ2. Here also increase in demand is less than proportionate
decrease in price (DQ2 < DP2). This situation is called relatively inelastic demand. In this
case the shape of demand curve is steep or semi-vertical.

Income Elasticity
Income elasticity measures the change in demand in response to change in the
consumer’s income. To compute income elasticity, the following formula is used:
Proporationate change in quantity demanded
EY =
Proportionate change in Income
Types of Income Elasticity

1. Zero income elasticity: Here, a change in income will have no effect on the
quantities demanded. For example, salt, cigarettes etc.

2. Negative income elasticity: In this case, an increase in income will lead to a

decrease in the quantity demanded. This happens in the case of inferior goods.
3. Positive income elasticity: In this case, an increase in income will lead to an
increase in quantity demanded. For most goods (normal goods) income elasticity is
positive.
Advertising Elasticity (Promotional Elasticity)

Advertising elasticity may be defined as ‘the responsiveness of demand to changes in

advertising or other promotional expenses. It is computed as follows.
Proportionate change in sales
Ea =
Proportionate change in advertising and other promotional exp……

Generally up to a certain point an increase in advertisement can bring about more than
‘proportionate increase in sales and beyond a particular point it may not click, and even
may become negative. Thus the impact of adverting and sales promotion can be
studied with the help of the concept of advertising elasticity.

Cross elasticity

This measures the change in demand for a commodity due to change in price of
another commodity. The commodities may be substitute or complementary. The
following formula may be applied:
Percentage change in quantity demanded of commodity A
ED =
Percentage change in the price of commodity B
The cross elasticity of demand for commodity A may be positive or negative; depending
upon the nature of relationship between commodities A and B.
The coefficient (ED) is positive if A and B are substitutes because the price change and
the demand change are in the same direction. If the price of B increases, the demand of
A also increases and vice versa. If A and B are complements the coefficient (ED) will be
negative because changes in the price of one commodity cause opposite change in the
quantity demanded of the other.

Price Mechanism (Market Mechanism)

Price mechanism refers to the free operation of the market forces of demand and
supply. It is the process of price determination by the interaction of free market forces of
demand and supply.

Determinants of supply
1) the number of sellers in a market, 2) the level of technology used in production, 3) the
price of inputs used to produce a good, 4) the amount of government regulation,
subsidies or taxes in a market, 5) the price of other goods sellers could produce, and 6)
the expectations among producers of future prices

Components of Price Mechanism

There are three components of price mechanism. They are: (a) principle of
demand, (b) principle of supply, and (c) equilibrium price.
The principle of demand states that there is an inverse relation between price and
demand. This means when the price increases, demand decreases and vice
versa.
The principle of supply states that there is a direct relation between price and
supply. This means when the price increases supply also increases and when the
price decreases supply also decreases. Equilibrium price is the price at which
demand and supply of a commodity are equal. It is shown in the following graph:
In the above graph DD is the demand curve and SS is the supply curve. OP is the
equilibrium price. It is determined at the point of interaction between demand and
supply. In other words, equilibrium price is determined where demand and supply are
equal.