Demand-Theory.pdf

DEMAND
THEORY
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What is a Demand ?
Demand can be defined as the willingness and ability of consumers to purchase a given
amount of a good or service at a given price.
In another term, demand for any commodity is the desire, ability and willingness to buy a
product or service.
Illustration:
● Desire to have a Mercedes but do not have enough money - Wishful Thinking
● In Spite of having the money, you do not want to spend on Mercedes - Want
● Your desire to have a Mercedes with the ability and willingness to pay for it combined
together will be - Demand

What is a Demand Function ?
Demand function shows the functional relationship between quantity demanded for a
commodity and its various determinants.
Demand functions measures how much of a given commodity consumers will demand at
various prices, income levels, or values of other variables that affect demand.
There are two types of Demand Functions:
● Individual Demand Function
● Market Demand Function

Factors determining Individual Demand Function
Individual Demand is a Function of :
Dx = f ( Px, PR, Y, T, E )
Where, Dx = Demand for the commodity X
Px = Price of the commodity X
PR = Price of the related goods
Y = Income of the consumers
T = Taste and Preference
E = Expectations of the buyers

Factors determining Market Demand Function
Individual Demand is a Function of :
Dx = f ( Px, PR, Y, T, E, N, DI, G )
Where, Dx = Demand for the commodity X
Px = Price of the commodity X
PR = Price of the related goods
Y = Income of the consumers
T = Taste and Preference
E = Expectations of the buyers
N = Number of Customers in Market
DI = Distribution of Income (DI)
G = Government Policy

Determinants of Demand Function
PRICE OF A COMMODITY X
The quantity demanded is INVERSELY related to the price of the product.
→ If price of the commodity falls, demand will increase.
→ If price of the commodity rises, demand will decrease.

INCOME OF THE CONSUMER (INFERIOR GOODS)
The quantity demanded is INVERSELY related to the income of consumer for normal goods..
→ If income of consumers falls, demand will increase.
→ If income of consumers rises, demand will decrease.

INCOME OF THE CONSUMER (NORMAL GOODS)
The quantity demanded is DIRECTLY related to the income of consumer for normal goods..
→ If income of consumers falls, demand will decrease.
→ If income of consumers rises, demand will increase.

PRICE OF RELATED GOODS (SUBSTITUTE GOODS)
Substitute Goods are those goods which are an alternative/option to another goods in
consumption. For instance, Tea and Coffee or Pepsi or Coca Cola
If the price of a substitute good X increases, the demand for another substitute good Y
increases and vice versa.

PRICE OF RELATED GOODS (COMPLEMENTARY GOODS)
There is a negative effect of price and quantity for complementary goods.
Complementary Goods: Petrol and Cars, Movies and Popcorn, DVD & DVD Players
As the price of Commodity X increases, quantity demanded of Complementary good Y
decreases.

TASTE AND PREFERENCE
❏ A positive change in tastes or preferences increases the demand. There is a shift of
demand curve towards right (up).
❏ A negative change in tastes or preferences decrease the demand. There is a shift of
demand curve towards left (down).

EXPECTATIONS OF BUYERS
If buyers expect the price of a good to go down in the future, they hold off buying it today, so
demand for that good decreases.
If buyers expect the price of a good
to go up in the future,the demand for
the good today increases.

NUMBER OF CUSTOMERS IN MARKET (POPULATION)
Number of customers is directly or positively related. Higher population lead to higher
demand.
When Population increases, the demand also increases.
When Population decreases, the demand also decreases.

DISTRIBUTION OF NATIONAL INCOME
There is a positive relationship between national income and market demand. The higher the
national income, the higher will be the purchasing power leading to increase in demand for
normal goods.
Similarly, if the national income falls,
the demand for normal goods decreases.

GOVERNMENT POLICY
If the government policy impacts the rate and prices of the commodity directly or indirectly,
the consumption of the normal goods decreases, decreasing the demand for that normal
goods.
Similarly, if government policy are flexible and reduces the rate and prices for the
commodity directly or indirectly, consumption of the normal goods increases, increasing the
demand for that normal goods.
For instance: When import taxes are high, the cost of the product increases . When prices
increases for a normal goods, people buy less of it. This decreases the demand for the
product.

What is a "Law of Demand” ?
“ Law of Demand” is a fundamental principle of economics. Law of demand suggests that
there is an inverse relationship between the price of a commodity and the quantity
demanded of that commodity, everything remaining constant.
Dx = f (Px), ceteris paribus Dx = Quantity Demanded of good X
Px =Price of the good X
As the price of good rises, the quantity demanded of the goods falls. Similarly, if the price of
goods falls, the quantity demanded of goods rises, ceteris paribus.
Ceteris Paribus = It is a latin term which mean “ all other things constant” or “nothing else
changes” .

Assumptions of the “Law of Demand”
❏ Price of the related goods remains constant
❏ The income of the consumers remains unchanged
❏ Expectations of the consumers remains same.
❏ Taste and Preferences of the consumers remains unchanged
❏ No change in size and composition of population.
❏ All the units of the goods are homogeneous in nature.
❏ Commodity should be a normal good.

Exceptions to the “Law of Demand”
❏ Speculative Demand
❏ Snob Appeal or Veblen Goods
❏ Using Price as an Index of quality
❏ Giffen Goods
❏ Possibilities of Future rise in Prices
❏ Highly Essential Goods
❏ Inferior Goods
❏ Ignorance of Consumers
❏ Abnormal Circumstances

Demand Schedule and Demand Curve
Demand Schedule is a tabular representation showing the different quantities of a
good that the consumers are willing to pay at different levels of prices during a
given period of time.
A demand schedule is the numerical representation of the law of demand.
Demand Curve is a graphical representation of the demand schedule showing the
different quantities of a good that the consumers are willing to pay at different
levels of prices during a given period of time.

Demand Schedule and Demand Curve
Demand Schedule Demand Curve
Price Quantity
5 10
4 20
3 30
2 40
1 50

Why is Demand Curve always Slope
downwards ?
❏ Law of Diminishing Marginal Utility
❏ Substitution Effect
❏ Income Effect
❏ New Consumers creating Demand
❏ Multiple uses of commodity

downwards ?
❏ Law of Diminishing Marginal Utility
When consumer consumes more and more of a same commodity at a point of time,
the utility derived from each additional unit consumed goes on declining, the
consumer is willing to pay less for more of additional unit of the commodity. This
diminishing characteristics is called “Law of Diminishing Marginal Utility”. This
shows the inverse relationship between price and quantity demanded.

downwards ?
❏ Substitution Effect
When the price of a commodity falls, consumers generally buy less of the substitute
commodity and more of the commodity whose price has fallen. This also reflects
the inverse relationship between price and quantity demanded.

downwards ?
❏ Income Effect
When the price of a good falls, the real income or the purchasing power of the
consumer rises. This means, individual consumes more of goods hence demands
more goods.
This shows inverse relationship between price and quantity demanded.

downwards ?
❏ New Consumers creating Demand
When the prices of a commodity falls, a new consumer class is added who are able
to buy the commodity, together with the existing consumers. This new consumer
class increase the demand for the good.
This also shows the inverse relationship between price and goods.

downwards ?
❏ Multiple uses of a commodity
When the price of a good falls, a new consumer class is added. With the decrease in
price, the commodity is put to various uses and demand for that commodity
increases and vice versa.
For instance.
If the price of milk decreases, individual who previously purchased milk only for
drinking will start buying more of milk and use it making various other milk
product either for consumption or for selling. This is increase the demand of the
milk.

Exception to “ Law of Demand”
Giffen Goods and Inferior Goods
Giffen Goods are non-luxury items that generate higher demand when price rises.
This is an exception to “Law of Demand”. Giffen goods have only few substitutes.
Example: Rice, Wheat and Bread are giffen goods. No matter the increase in price
of such commodities, the demand is always there either at constant or increasing.
Inferior Goods are those goods whose demand declines when income rises.
Consumers consider the commodity to be below standard if the price decreases.
Example: Instant Noodles, Canned Food Products

Veblen Goods or Goods for Status
Veblen goods are those goods whose demand increases with the increase in the
price. They are also called as prestigious goods or goods of status. Such goods are
named after Thorstein Veblen
Example: Diamond, Gold, Silver, Exclusive and Limited watch. Art piece etc.

Demonstration Effect
When consumer buying behaviour is imitative in nature, it doesn’t follow the law of
demand. For instance, If a certain group of consumers are buying goods by
imitating the consumption pattern of the higher income group, the demand is
higher for higher price.

Emergency
The intense situation and in case of emergency, the ‘Law of Demand” does not
hold. For instance, situation like curfew, drought or famine doesn't consider any
Law of Demand.

Change in Quantity Demanded
(Movement Along the Demand Curve)
Movement along the demand curve is caused by the change in the price of good,
keeping other things constant.
Expansion of Demand: It refers to the rise in demand due to the fall in price of
good.
Contraction of Demand: It refers to the fall in demand due to the rise in price of
good.

Change in Quantity Demanded
Expansion of Demand and Contraction of Demand
P
P1
Q Q1
Price
Quantity
P
Q 1 Q
Price
Quantity
P1
Expansion of Demand Contraction of Demand

Change in Demand
(Shift of Demand)
Shift in Demand is caused by changes in factors other than price of the commodity.
Some of such factors are:
● Consumer’s Income
● Price of Related good
● Consumers’ taste and preferences
● Consumers’ expectation
● Distribution of National Income
● Government Policy

Change in Demand
(Shift of Demand)
Increase in Demand
This refers to more demand at a given price. It is indicated by the rightward shift
of demand curve. This is due to :
● Increase in the income of the consumers
● Increase in the price of substitute goods
● Decrease in the price of complementary goods
● Favorable change in customers’ taste
● Consumers’ expectation of rise in price of the good in near future

Change in Demand
(Shift of Demand)
Decrease in Demand
This refers to less demand at a given price. It is indicated by the leftward shift of
demand curve. This is due to :
● Decrease in the income of the consumers
● Decrease in the price of substitute goods
● Increase in the price of complementary goods
● Unfavorable change in customers’ taste
● Consumers’ expectation of fal in price of the good in near future

Change in Demand
(Shift of Demand)
P
Q Q1
Price
Quantity
Increase of Demand Decrease of Demand
D1
D
P
Q 1 Q
Price
Quantity
D
D1

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