Introduction to Demand Theory

From WikiEducator
Jump to: navigation, search


SLMtitle.png Demand Analysis

SLMinto.png Introduction

What is demand in economics?

People demand goods and services in an economy to satisfy their wants. All goods and services have wants satisfying capacity which is known as “UTILITY” in economics. Utility is highly subjective concept; it is different from person to person. Utility (level of satisfaction) is measured by means of introspection. By demand for goods and services economists essentially mean is willingness as well as ability of the consumer in procuring and consuming the goods and services. Thus, demand for a commodity or service is dependent upon (a) its utility to satisfy want or desire (b) capability of the prospective consumer to pay for the good or service. In nutshell therefore we can state that -

When desire is backed by willingness and ability to pay for a good ot service then it becomes Demand for the good or service

Conceptually, demand is nothing but consumer’s readiness to satisfy desire by paying for goods or services. A desire accompanied by ability and willingness to pay makes a real or effective demand.

SLMobj.png Learning Objectives
After reading this chapter, you are expected to learn about:

  • Understand the Concept of Demand
  • Understand the Factors impacting Demand
  • Understand the relationship between Demand and Price
  • Understand the relationship between demand and other factors like Income of a consumer, Price of related goods, Advertisement, Change in Population etc

Significance of the concept of demand

Demand is one of the most important decision making variables in present globalised, liberlised and privatized economy. Under such type of an economy consumers and producers have wide choice. There is full freedom to both that is buyers and sellers in the market. Therefore Demand reflects the size and pattern of the market. The future of a producer is depends upon the well analysed consumer’s demand. Even the firm dose not want to make profit as such but want to devote for ‘customer services’ or ‘social responsibilities’. That is also not possible without evaluating the consumer’s tastes, preferences, choice etc. All these things are directly built into the economic concept of demand.

The survival and the growth of any business enterprise depends upon the proper analysis of demand for its product in the market. Demand analysis has profound significance to management for day today functioning and expansion of the business. Thus the short term and long term decisions of the management are depend upon the trends in demand for the product. Any rise or fall in demand for the product has to be to find out reasons and revised production plans, technology or change in advertisement, packging, quality etc.

The market system works in an orderly manner because it is governed by certain certain Fundamental Laws of Market known as Law of Demand and Supply The demand and supply forces determine the price of goods and services in the market. The laws of demand and supply plays very important role in economic analysis .Thomas Carlyle, the famous 19th century historian remarked “It is easy to make parrot learned in economics; teach a parrot to say demand and supply” The most important function of microeconomics is to explain the laws of demand and supply, market mechanism and working of the price system. Here we will discuss the concept of demand and demand analysis.

Law of Demand

Law of demand states that whenever price of a product increases then the demand for that product decreases and vice versa provided other things remain constant. Here these other things are Income of the individual, Price of related goods, Tastes and preferences, Population, Advertisement etc. While studying the law of demand the direct relationship between price and demand is studied. This is because under the economic theory price of a product is considered as the main determinant of demand in the short run period.

Understanding Demand Function

Demand Function

As per the law of demand, demand is function of price provided other things remain constant

Dx = f (Px) Dx is demand for commodity X, which is dependent variable, and Px is the price of X, which is independent variable. The demand function if consideredv as linear or straight line function can be expressed in the form of following equation:

Dx = a + bPx

Where a and b are constants. 'a' is intercept and 'b' quantifies the relationship between Dx and Px. The demand price relationship can be both linear and non-linear. The relation ship between demand and the price can also be expressed as follows:

∆Px → ∆Qdx

↑ Px → ↓ Qdx

↓ Px → ↑ Qdx

Here Qdx indicates the change in the quantity of demand if the price changes and as per the law of demand an inverse or opposite relationship between price and quantity demanded of a commodity is assumed.In simple words, if the price of a product is high then its demand will be low and vice versa. This relationship is also exhibited in the digrammatic representation of the demand curve. To state more clearly, if we are digrammatically representing demand by taking demand on the X axis and the price of the product on the Y axis then we always get a demand curve sloping downwards from the left to right indicating the price demand relationship as expressed by the law of demand.

Understanding Demand Schedule

Demand Schedule

A demand schedule is the a tabular presentation of the different levels of prices at corresponding levels of quantity demanded of that commodity. It shows at different levels of prices higher or lower how the quantity demanded is different. This shows the relation ship between price and quantity demanded of a commodity i. e. law of demand.

Demand Schedule of Note Books
Price per Notebook (Px) Quantity of Notebooks Demanded (Dx)
25 2
20 4
15 8
10 10
8 12
Demand Curve

Demand Curve

Demand curve is the graphical representation of the demand schedule. Demand curve is obtained by plotting a demand schedule on a graph. As discussed earlier, demand curve slopes downward from left to right. It has a negative slope. It shows there is inverse relationship between price and quantity demanded of a commodity.

Again, as discussed earlier, Demand curve can be both Linear or Non-linear - If the Demand Curve is Non-linear then the eaquation of Demand is as follows:

Dx = aPx -b

If Demand Curve is Linear, then the equation of Demand curve is taken as follows:

Dx = a – bPx

The digrammatic representation of the Demand Curve can be as follows:


Understanding Variation of Demand

Variation in Demand

Expansion and Contraction of Demand

When demand changes due to change in price of that commodity then the phenomenon is known as variation or expansion or contraction in demand whereas when demand changes due to other factors, that is known as change in demand.

When we say the variation in demand takes place in the market for a particular product or service means this phenomenon occurs ( that is rise or fall in demand) only because of change in its price.Here consumer remains on the same demand curve. He shifting up or down on the same demand curve as shown in dig. Therefore law of demand is concerned with the phenomenon that is VARIATION IN DEMAND which is accompanied by Rise and Fall in price, or known as expansion and contraction in demand.

Change in Demand

When we say the change in demand takes place in the market for a particular product or service means due change in its other factors like income, taste, preferences etc and not because of its price. Thus due to rise or fall in income of a consumer or change in preferences, taste etc there is rise or fall in demand for a commodity or services. Here quantity demanded of a commodity is more or less at same or higher or lower price. Here consumer shift on higher demand curve to the right or lower demand curve to the left. This phenomenon is known as Change in Demand which is accompanied by increase and decrease in demand.

Why the Demand Curve is Downward Sloping?

Why does the demand curve slope downward from Left to Right?

The reasons behind the law of demand and the shape of demand curve are following.

  • Income Effect When price of a commodity falls, real income (i.e. purchasing power) of a consumer increases in terms of that commodity. So our rational will consume more of relatively cheaper. Such increase in demand due to increase in real income is called as income effect.
  • Substitution Effect When price of commodity falls, its becomes relatively cheaper compare to its other close substitutes Rational consumer will definitely buy more units of relatively cheaper good than relatively dearer whose price has remain same to maximize the satisfaction. On account of this factor is known as substitution effect.
  • Diminishing Marginal Utility This also responsible for the for the increase in demand for a commodity when its price falls. When a person buys a commodity he exchanges his money income with the commodity in order to maximize his satisfaction. He continues to buy goods and services so long as marginal utility of money is less than marginal utility of commodity . (MUm < MUx )

Therefore general shape of demand curve is negatively sloping downward from left to right. It positively slopes upward from left to right in case of inferior , Giffen or complimentary goods.

Understanding About Other Determinants of Demand

Other Determinants of Demand

Along with price there are many other factors which also influence the demand for a commodity. They are prices of its close substitutes, income of consumer, wealth, size of population, fashion, taste of consumer etc.

Therefore new demand function for long run is :

Dx = f (Px, Py,_Pn, Y , W, A, F ,Zp, T, etc ) Where: Dx = Demand for a commodity

Px = Price of a commodity

Py = Price of a Y good which is close substitute for X good

Pn = Prices of n number of close substitutes

Y = Income of a consumer and Engle curves

W = Wealth of a consumer

A = Advertisement and Publicity

F = Fashion or demonstration effect

Zp = Size and composition of population of population

T = Taste and Preferences of a consumer

Exp = Expected price and utility at equilibrium

Cr = Existing short- term credit facilities

And there can be many more similar factors that may impact demand. All the above factors play very important role in the determining demand for a commodity or service if all the above stated factors are taken as variable. Here, it is important to understand that Law of Demand assumes partial equilibrium which means that if other things remain constant then whenever the price of a commodity changes then the demand for that commodity changes in the opposite direction.

If on the other hand, general equilibrium analysis is used in explaining the demand then impact of some of these other factors can be explained as follows:

  • Price of a commodity – As the price of commodity falls a commodity becomes cheaper in a market and rational consumer will try to demand more units of the same to maximize his satisfaction and vice- versa when price rises. Therefore rise in price fall in demand and fall in price rise in demand.
  • Prices of Close substitute - Demand for a commodity is also depend upon the prices of its close substitutes. If price of close substitute falls then demand for that commodity also falls and vice-versa. Therefore demand is also depends upon the number and degree of close substitutes available in market and the range of price change.
  • Income of a consumer - Consumer’s income is the basic determinant of the quantity demanded of the product. Generally the people with higher disposable income spend a larger amount of income than those with the lower income. Income demand relationship is more varied nature than that between demand and its other determinants. To explain the varied relationship between income and demand we classify goods and services into four broad categories, viz.(a)essential consumer goods; (b) inferior goods; (c) normal goods; and (d)prestige good or luxury goods. This is shown through Engels law of family expenditure.

a) Essential Consumers goods b) Inferior goods c) Normal goods d) Prestige or Luxury Goods 4. Wealth of a consumer 5. Advertisement and Publicity 6. Fashion or Demonstration Effect 7. Size and Composition of Population

Types of Demand


  • Direct demand and Derived demand.
  • Individual demand and Market demand.

Domestic and Industrial Demand Autonomous and Induced Demand New and Replacement Demand etc.

SLMact.gif Activity




SLMsaq.gif Self-Assessment Questions (SAQs) {{{n}}}

SLMsum.png Results

MU KEY.jpg Key Terms

Icon activity.jpg

Extension exercise

Enter your text here

SLMref.png References and Bibliography

SLMref.png Further Readings

Text in mooodle

Quiz in Moodle