Theory of Demand

1. Module II
Theory of Demand
1) Demand
- quantity demanded of a commodity per unit of time at a given price.
- desire, backed by ability and willingness to pay
-Demand is always expressed at a price and a unit of time
The Law of demand
-it expresses the relationship between price and demand
-The quantity of a product demanded per unit of time.
It increase when its price falls and decreases when its price increases other
factors remaining the same (paribus cetris)

2. 2. Demand determinants
Price
Consumers Income
Expectation Determinants of
Demand
Advertisement Price of related Taste &
Effect goods Preferences

3. The law of demand states that other things being equal, demand varies
inversely with price
Assumptions
1. Perfect competition
2. No change in income
3. No change in taste and preference
4. Price of related commodities should not change
5. Commodity…. A normal one
6. Size of population should not change
7. No expectation of rise in price or related goods

4. Demand Schedule
It is a services of quantities which consumers would like to buy per unit of
time at different prices
The Demand Curve
It is a locus of points showing various alternative price - quantity
combination
Market demand schedule
-It is the horizontal summation of all the individual demand curves

5. Market Demand Schedule

6. Why the demand curve stops downwards to the right?
1) Income effect
2) Substitution effect
3) Diminishing marginal utility
Exception
Giffen Fear of Veblen Ignorance Expectation
Paradox Shortage Effect of Buyers of price rise
Change in Demand
Extension or Shift in Demand
Contraction

7. - Change in demand due to change in price – then extension or
contraction
- This is movement along the same demand curve
Extenstion or Contraction of Demand

8. -If demand changes due to other factors, other than price – then shift in
demand curve
-Two types of shifts - upward shift or increase in demand and the
downward shift or decrease in demand
-When consumers are ready to buy more at the same price or willing to pay
more for buying the same quantity as before – Increase in demand
-When consumers buy less at the same price or pay less for buying the same
quantity as before
Increase and Decrease of Demand

10. Demand Forecasting
-To predict future demand for a product
- Essential for planning and scheduling production, purchase of raw
materials, acquisition of finance and advertising
-Highly essential – where large scale production is being planned and where
there is long gestation period
-Essential for new firms to avoid over production or under production
Types
Short term Medium term Long term

11. Factors involved in demand forecasting
1. Time period
2. Level of forecasting
Factors 3. Purpose – general or specific
4. Methods of forecasting
5. Nature of commodity
6. Nature of competition
Determinants of demand forecasting
Goods demanded
Capital goods Durable consumer Non- durable
goods consumer goods

12. Objectives of demand forecasting
1. Helping for continuous production
2. Regular supply of commodities
3. Formulation of price policy
4. To formulate effective sales promotion
5. Arrangement of finance
6. To determine the production capacity
7. Labour requirement
Criteria of Demand forecasting
1. Accuracy
2. Plausibility
3. Durability
4. Availability
5. Economy

13. Techniques /Methods of demand forecasting

14. Elasticity of Demand
-refers to the degree of correlation between price and demand
-Is the measure of the responsiveness to a change in the price
Types
Price elasticity Income Cross elasticity
of demand Elasticity of demand of demand
Price Elasticity of demand
- is the proportionate change in the quantity demanded in response to
proportionate change in price

15. Proportionate change in quantity demanded
Price elasticity =
Proportionate change in price
Change in quantity demanded
quantity demanded
=
Change in price
Price

16. Symbolically
q
ep =
q
= q /q / p
p p
p
q p q p
Ep = x = x
q p p q
Where ep stands for price elasticity
q for quantity, p for price, for small change

17. Degrees or Types of price elasticity
- Five cases of price elasticity
a) Perfectly elastic (infinite)
Y
Price D Ed = 
0 X
quantity
- A small change in price leads to large percentage change in quantity
Demanded
- Shape in horizontal straight line

18. b) Perfectly inelastic demand
Y D
Price Ed = 
o quantity X
-How much ever the price may fall or rise, the amount demand remain the
same
-Demand for a commodity does not show any response to a change in the
price

19. c) Relatively elastic demand
-Both the above are extreme limits and are seldom in real life
-So usually it is somewhere between these two extreme limits
-It is either more than zero or less than infinity

20. d) Relatively inelastic demand
-The quantity demanded changes by a smaller percentage than the change in
price

21. e)Unit elastic demand
-Elasticity of demand is equal to one
- The response to change in quantity demanded is the same as the change in
the price of a commodity

22. Measurement of price elasticity of demand
-Four methods
1) Total outlay method
- we compare the total outlay of the purchaser (total revenue) before
and after the variation in price
- For marshall – total outlay = Price X Quantity
- Three types of elasticity
a) Unity
- when total amount spent on the purchase of the commodity
remains the same, even thought the price has changed
b) Greater than one
- The money spent on the purchase of a commodity increases when
the price of the commodity falls or vice versa
c) Less than one
- The total amount of money spent increases with every rise in the
price and decreases with every fall in the price

24. 2) Proportion method
Percentage change in quantity demanded
Price elasticity =
Percentage change in price
3) Point Method
lower segment
Price elasticity =
Upper segment

26. d) Arc Method

27. Factors determining price elasticity of demand

28. Business Application of Price Elasticity
1) For Managerial decision Making
2) For determination of prices
3) For Finance minister to impose taxes
4) To determine terms of trade between countries
5) For determination rewards to the factors of production
6) Useful for labour union to bargain for wages
7) Enables the govt. to declare and decide as to what industries should
be made as public utilities
8) Rate of exchange between two currencies
9) “Paradox of poverty” in the midst of plenty

29. Income Elasticity of demand
-is the degree of responsiveness of quantity demanded of a good to a
change in income of the consumers
- is the ratio of proportionate change in the purchase of goods to the
proportionate change in income
Proportionate change in the purchase of a commodity
-Income Elasticity
Proportionate change in income

30. Types of Income Elasticity

32. III) Cross Elasticity of Demand
-is the ratio of the percentage change in demand for a good to the
percentage change in the price of other goods
% change in demand for commodity x
Cross Elasticity of demand =
of x and y % change in the price of commodity y

33. Theory of production
-one of the prime concern of business managers is to achieve optimum
efficiency in production or minimizing cost
-Fundamental question, which managers face to minimise cost are:-
a) How can production be optimised so that cost is minimised ?
b) How does output change when quantity of inputs is changed
c) How does technology matter in reducing the cost of production ?
d) How can the least cost combination of inputs be achieved
e) Given the technology, what happens to the rate of return when more
plants are added to the firm
- The theory of production provides a theoretical answer
Meaning of production
-Production means transformation of input into an output with value
added.
-Refers to the creation of value or wealth

34. Input – is simply anything which the firm buys for use in its production
or others process
Output – is any good or services that covers out of production process
Input
Fixed input or Variable input or
Fixed factor Variable factor
-In economic sense, a fixed input is one whose supply is inelastic in the
short period
-In Technical Sense – is one that remain fixed for a certain level of
output
-In Economic sense - a factor whose supply in the short period is elastic
- In technical sense – a factor, which changes with a change in output

35. Time
Short run Long run
Supply of certain inputs is Supply of all inputs is elastic
Fixed or inelastic except technology
eg. Building, machinery
Production Function
is the functional relationship between physical inputs (factors of
production) and physical output (goods produced)
it depends on
a) Quantities of resources
b) State of technology
c) Possible processes
d) Size of the firm
e) Nature of firm’s organization

36. -Any change in the above factors will change the production function also
O = f (a,b,c,d)
Where O = stands for production
a to d stands for inputs
f – stands for function
Nature of production function

37. Types of Production function
Types
A. Fixed proportion and Variable Proportion
B. Short period and Long period
C. Cobb-Douglas Production fn.
A. Here the factors of production are used in fixed proportion.
Variable Proportion Prodn. Fn.
 In variable proportion production function the proportion of factor inputs are
varied.
 In short period we have a case of the law of diminishing returns or the laws of
returns to a variable factor.
 When all factors are varied we have a case of the Laws of Returns.

38. Fixed Proportion Production Function
OR represents fixed capital labour ratio where two units of capital and three
units of labour can produce 100 units of outputs.
To produce 200 units we have to double the factor inputs.
A,B,C are ISOQUANT curves.
An ISOQUANT is defined as a curve representing different combination of
inputs which will yield a certain level of output.

39. Variable Proportion Production Function
In order to produce 100 units of outputs either OY1 and OX1 or OX3 and OY3
combinations of input can be used.
If the quantities of one input is decreased, the quantities of other inputs have to be
increased to produce a given output.

40. B. Short period and long period production function.
In short period one or more inputs are fixed. Eg: machinery.
To produce more the management has to increase the variable input. Eg: Labour.
This is also called the variable proportion of production function.
In the long period all factors are variable,
Therefore the management can vary any factor of production to increase the
output.
C. Cobb- Gouglas production function.
Here, the output is goods produced by the manufacturing industry.
Labour and capital are inputs.
Cobb- Gouglas production function says that labour contributes about 75%
increase in manufacturing production where capital contributes only 25%.

41. The Law of Variable Proportions or
The Laws of Returns to a Variable input or
The Law of Diminishing Returns.
It occupies an important place in business economics.
It examines the production function with one variable input keeping the
quantities of other inputs fixed.
 When the combination of inputs are altered resulting output also changes.
Definition : When more and more units of a variable (factor) input are applied
to a given guarantee of fixed inputs, the total output may initially increase at
an increasing rate and then at a constant rate but it eventually increase only at
a diminishing rate.
 “ An increase in labour and capital applied in the cultivation of land causes
in general a less than proportionate increase in the amount of produce raised

42. unless it happens to coincide with an improvement in the arts of agriculture”
Alfred Marshal.
Assumptions : 1. The state of technology of production remain unchanged
2. Some inputs are kept fixed during the process of
productions.
3. The law is based on the possibility of varying the
proportions in which various factors of productions can
be combined to produce a product.
Illustration of the law :

43. In the above illustration capital employed is fixed and only labour is
varied
 We derive marginal and average output from total output
Marginal Product – Is the addition to total product which can be
produced by addition of more units of the variable input
Average Output – Is the ratio of total output to the amount of the variable
input.
 The behavour of total, average and marginal output is shown in the
following diagram:

44. Stage 1
 Total Product increases at an increasing rate
 Both marginal product (MP) and Average Product (AP) are rising
 The boundary line of the first stage is reached when AP and MP are
equal.
 This stage is known as stage of increasing returns, because the AP of
the variable factor is increasing through out this period
Stage 2
Total Product (TP) continuous to increase but at a diminishing rate.
When MP is zero Total Product is maximum.
 Both MP and AP are declining
 MP is below AP
 At the end of the second stage at the point M, MP to the variable factor
becomes zero while the total product reaches the highest point.

45. It is called the stage of diminishing returns as both AP and MP continuously fall.
Stage 3
 Total product declines and TP curve slops downwards.
 MP is negative as it goes below the OX axis.
 AP decreases still further.
This stage is called the stage of negative returns.
 Stage 1 and Stage 3 are symmetrical
 In stage 1 fixed factor is too much, hence MP is falling.
 In stage 3 variable factor is too much, hence MP is negative
 The stage of operation rational producer

46. Stage of operation
 A rational producer will not choose stage 3
 He will not use stage 1 because he will not be making maximum use
of the fixed factors.
 So long as AP, MP and TP are rising he will not stop producing
 He goes to stage 2 where MP and AP of the variable factor are
diminishing
 Hence the stage 2 represents the range of rational production
decisions

47. The Laws of returns to scale
 It refers to the long run analysis of production .
 Shows how output can be increased by changing the factor inputs.
 In the short run fixed factors like machinery can be altered.
 In the long period all factors are variable.
 Under the laws of returns to scale all productive factors or inputs are
increased or decreased in the same proportion simultaneously.
 Returns to scale means the change in output due to changes in the scale
of production

48. Three phases of the returns to scale
 If the increase in output (MP) is proportional to increase in the
quantities of input, returns to scale are said to be constant.
 A doubling of input causes a doubling of output
 If the increase in output is more than proportional, returns to scale are
increasing.
 If the increase in output is less than proportional returns to scale is
diminishing.

49.  The above table it is seen that as all the factor inputs are together
increased to the same extent the MP or returns increases first upto a point
then constant for some further increase in the scale and ultimately starts
declining.
 This is illustrated in the following diagram:

50. Increasing returns to scale
It means that output increases in a great proportion than increase in
inputs
Reasons
 The effect of Technical and Managerial indivisibility
 Equipments are under utilised in the beginning
 When the scale of operations are increased they are put into
maximum use and hence the output or returns increases more than
proportionately
Higher degree of Specialisation
Constant Returns to Scale:If the scale of inputs are increased in a
given proportion and the output increases in the same proportion
returns to scale are said to be constant.

51. Also called linear and homogeneous production or homogeneous
production function of the first degree in mathematics.
Diminishing returns to scale
When the output increases in smaller proportion than the increase in all
inputs decreasing returns to scale is said to prevail.
 This happens when a firm goes on expanding by increasing all the
inputs.
Reasons
 The entrepreneur factor may be fixed while all other inputs are variable.
 Because of increasing difficulties of management, coordination and
control.
 When the firm becomes gigantic it becomes difficult to manage.

52. Importance of diminishing returns
Whenever some factors of production are fixed and cannot be
varied and other factors are varied then the techniques of production
remaining the same dimnishing returns are bound to follow sooner or
later. There is no escape.
 Science and Technology may keep the operation of dimnishing
returns in check but it is bound to operate.