Demand Theory

2.  Demand –
Desire + ability to pay + willingness to pay
Demand is relative term –
Price
Time
Place

3.  Price
 Consumer Income
 Taste, preference and fashion
 Prices of related goods
 Government policy
 Custom and tradition
 Advertisement

4.  If other things remain constant, when
price increases demand contracts and
when price decreases demand
expands. Price and demand are
inversely proportionate.
D = a - bP

5.  Law of diminishing marginal utility
 Income effect
 Substitution effect

6.  Shows the amount of a good that will be
purchased at alternative prices.
 Law of Demand
› The demand curve is downward sloping.
Quantity
D
Price

7.  Giffen Goods (Giffen’s paradox)
 Prestigious goods ( Veblen effect)
 Buyers illusions (Expectations)
 Necessary goods
 Brand loyalty
 Scarcity
 Speculative goods

8.  Elasticity is a measure of responsiveness
of one variable to another variable.
 Can involve any two variables.
 An elastic relationship is responsive.
 An inelastic relationship is unresponsive.

9.  Price Elasticity of demand
 Income elasticity of demand
 Cross Elasticity of demand

10.  Causality: denominator numerator!
 An elastic response is one where numerator is
greater than denominator.
i.e., %∆Q>%∆P so Ep >1
› Imagine extreme example.
 An inelastic response is one where numerator
is smaller than denominator.
i.e., %∆Q<%∆P so Ep <1
› Again, imagine extreme example.

11.  Perfectly Elastic D
Ep =infinite
 Perfectly Inelastic D
P
Q
P
Q
Ep =0
D
D

12. Q1 Q2 Q2’
P1
P2
D’
D
D’ is relatively more elastic
than D
P
Q

13.  Point elasticity
› Point elasticity is
responsiveness at a
point along the
demand function
Ep =∆Q/Q1
∆P/P1
simplifying:
Ep =(∆Q/∆ P)* P1 /Q1
 Price (Rs.)
Q
Q1
P1
D

14.  Point elasticity
› Point elasticity is
responsiveness at a
point along the
demand function
Ep =∆Q/Q1
∆P/P1
simplifying:
Ep =(∆Q/∆ P)* P1 /Q1
 Price (Rs.)
Q
Q1
P1
D

15.  Point elasticity
Ep =(∆Q/∆ P)* P1 /Q1
 SupposeP=17000
 Q=56-0.002*17000
 Q=56-34=22
 Plug into equation gives:
Ep =(-0.002)* 17000/22
Ep =-34/22=-1.54
 Price (Rs)
Q
22
17k
D

17.  Arc elasticity:
Responsiveness along a
range of D. function
Ep =∆Q/((Q1+Q2)/2)
∆P/((P1+P2)/2)
simplifying:
Ep=(∆Q/∆P)*((P1+P2)/(Q1+Q2))
Price ($)
Q
Q2
P2
P1
Q1
Avg.
responsiveness
D

18.  Arc elasticity
Ep =(∆Q/∆P)*((P1+P2)/(Q1+Q2))
 Look atP range 16k - 17k
 Q=56-0.002*17000
 Q=56-34=22
 Plug into equation gives:
Ep =(-0.002)*(33000/46)
Ep =-66/46=-1.43
Price ($)
Q22
17k
D
24
16k

19.  Nature of commodity
 Availability of substitute
 Multiplicity of uses
 Habit
 Proportion of income spent
 Price range

20.  Pricing Decision
 Fiscal policy
 Labour market
 International trade

21.  Recall demand function is:
Q=f(P,I,Prelated,Tastes,Buyers,Expectations...)
 Change in I causes shift in demand.
 Size of shift depends on income elasticity.
 EI
=%∆Q/%∆I
 Focus again on point formula.
 Value of EI
determines type of good.

22.  Sign indicates normal or inferior
EI
>0 implies normal good.
EI
<0 implies inferior good.
 Normal goods may be necessity or
luxury.
› If EI
>1 then this is luxury (responsive to
income).
› If 0<EI
<1 then this is necessity (unresponsive to
income).

23. QX=f(PX ,I,PY,Tastes, Buyers,Expectations...)
 Change in PY causes shift in demand for X.
 Size of shift depends on cross-price elasticity.
 EXY
=%∆QX /%∆PY
 Sign indicates relationship between two goods
EXY
>0 implies goods are substitutes.
EXY
<0 implies goods are complements.

24.  Production planning
 Evolving sales policy
 Fixing sales targets
 Determining price policy
 Inventory control
 Determining short-term financial planning

25.  BUSINESS PLANNING
 MANPOWER PLANNING
 LONG-TERM FINANCIAL PLANNING

26. Survey methods:
 Consumer interviews
 Opinion poll
 Experts opinion
 End-use method
Statistical methods:
 Trend Analysis
 Regression Analysis

27.  The supply curve shows the amount of a
good that will be produced at
alternative prices.
 Law of Supply
› The supply curve is upward sloping
Price
Quantity
S0

28.  Input prices
 Technology or
government
regulations
 Number of firms
 Substitutes in
production
 Taxes
 Producer
expectations

29.  An equation representing the supply
curve:
Qx
S
= f(Px , PR ,W, H,)
› Qx
S
= quantity supplied of good X.
› Px = price of good X.
› PR = price of a related good
› W = price of inputs (e.g., wages)
› H = other variable affecting supply

30. Price
Quantity
S0
20
10
B
A
5 10
A to B: Increase in quantity supplied

31. Price
Quantity
S0
S1
8
5 7
S0 to S1: Increase in supply
6

32.  The amount producers receive in excess of the
amount necessary to induce them to produce
the good.
Price
Quantity
S0
Producer
Surplus
Q*
P*

33.  Balancing supply and
demand
› Qx
S
= Qx
d
 Steady-state

34. Price
Quantity
S
D
8
7

35. Price
Quantity
S
D
5
6 12
Shortage
12 - 6 = 6
6
7

36. Price
Quantity
S
D
9
14
Surplus
14 - 6 = 8
6
8
8
7

37. THANK
YOU …