Demand Theory

Demand Theory
The Concept
Demand is the relative term that can be defined with the help of four factors:
1. Desire
2. Ability to pay
3. Willingness to buy
4. Time
Demand Function/Analysis
In demand analysis, at any point in time, the quantity of goods and services can be determined by the
variables or determinants.
• 1. price of product (P)
• 2. price of substitute and complementary goods (Ps/ Pc)
• 3. Level of Income (I)/ Disposable income(Yd)
• 4. Tastes and preferences of consumers (T)
• 5. Advertisement (A)
• 6. Population (N),
• 7. Others (u)
• Hence, the demand for the commodity x is given by:
(Dx) = f(Px, Ps/Pc, I/Yd, T, A,N, u)

Price and Demand relation
The relationship is known to be ‘inverse’.

D=f (Px), where
D= demand
P= price of good (x).
Demand here is the dependent variable, whereas price is Independent variable.
Demand Schedule [ Individual and market]
It is the tabular arrangement of the demand/price relationship.

Individual demand Schedule shows the quantity of output purchased by the individual over given
period of time. It shows present demand behavior.
Price of Mangoes Quantity demanded
80 2
70 4
60 6
50 10
Market demand
• It shows the aggregate quantity demanded by all the buyers in the

market.
Price of QD QD QD TOTAL OR
Mangoes (A) (B) (C) MARKET
DEMAND
4 1 1 3 5
3 2 3 5 10
2 3 5 7 15
1 5 9 10 24
Demand Equation
The below formula can represent the linear demand function:

D = a – b * P where,
D= Quantity demanded,
a is the constant parameter which means initial demand is irrespective of price.
b is the constant value representing the functional relationship of demand with the price, the negative sign shows
the negative function or the inverse relationship between price and demand.
Image:
https://www.toppr.com/guides/business-economics/theory-of-demand/movement-along-the-demand-curve-and-shi
ft-of-the-demand-curve/
https://www.toppr.com/guides/fundamentals-of-economics-and-management/equilibrium/change-in-equilibrium-
price-due-to-shift-in-demand/#:~:text=Extension%20and%20Contraction%20in%20the%20demand%20curve,-The
%20change%20in&text=Further%2C%20a%20reduction%20in%20the,along%20the%20demand%20curve%20itself.
Law of Demand
Demand varies inversely to the change in price. Other things remain constant demand is inversely
related to price.
Term used – Change in QD with respect to change in P
Assumptions
1. Constant Income
2. Constant Taste and preferences
3. No change in fashion
4. No change in the price of the related goods
5. No future price change
6. No change in population
7. No change in available goods
8. No change in government policy
9. No change in weather condition
Extension and Contraction of Demand
Q1 TO Q2 /Q2 TO Q3- Extension; Q4 TO Q3/Q3TO Q2- Contraction

Increase and Decrease in Demand( Change in DD)
Image:
https://www.economicsdiscussion.net/demand/changes-in-demand-2-
ways/21811#
Exceptions of the law of demand
Reason for the shift (Increase and decrease) in demand
curve
1) Rise in the income.

2) Increase in the prices of substitute goods.
3) Decrease in the prices of complementary goods.
4) Change in taste and preferences of consumers.
5) Change in population
6) Advertisement
Exceptions of Law of Demand
Positive relationship ( upward DD curve)

1. Giffen Goods ( Sir Robert Giffen)
2. Inferior Goods
3. Articles of snob appeal/Prestige goods
4. Speculation ( Stock market)
5. Consumer’s Psychological Bias
Price , Income and Cross Demand
• D = f(P) • D=f(M) • Dx=f(Py),

• Dx=DD of X
• Py= Price of Y
INCOME
Price DD CROSS DD
DD
Elasticity of Demand
The elasticity of demand measures responsiveness for demand for a

commodity to change in variables confined to its demand function.
Elasticity of demand=
percentage change in quantity demanded/percentage change in
demand determinants
Types of elasticities of demand
Price elasticity
Income elasticity
Cross elasticity
Price elasticity
• The extent of response of demand for a commodity to a given change in price, other demand
determinants remaining constant.
• The co-efficient of price elasticity (e) = % change in QD/ % change in price.
Or
According to Mrs. Robinson’s definition “ The elasticity of demand at any price.. Is the proportional
change of amount purchased in response to a small change in price, divided by the proportional
change of price”
Ep= Q/Q/ P/P
OR
e= Q/Q * p/ p, by rearranging, (-)
Q/ P* P/Q
Q= Q2(New QD)-Q1(Initial QD); P= P2 (New price)- P1(Initial price)

Example
Prices of Apples (Rs.) Quantity Demanded (Kg.)
20 (P/P1) 100 ( QD/Q1)
21(P2) 96 (Q2)
Types of price elasticity
• Unitary elastic demand e=1

• Elastic demand e>1;
• A. Perfectly elastic
• B. Relatively elastic
• Inelastic demand e<1
• A. Perfectly inelastic
• B. Relatively inelastic
Unitary elastic demand e=1
Perfectly elastic e=∞
Relatively elastic e>1
Perfectly inelastic e=0
Relatively inelastic e<1
Measurement of price elasticity
• 1. Ratio method
• 2. Total Revenue method
• 3. Point method
Ratio method
• Also known as the percentage method;

• e= % change in Q/ % change in price;
• = change in Q/ quantity(Q)* Price (P)/Change in P

Total Revenue method or Total outlay method
• Total Revenue= Price * Quantity purchases/ sold

price Quantity Total revenue Elasticity of
P*Q Demand
Original 2 10 20 ----
Change 4 5 20 e=1
1 20 20
Change 4 4 16 e>1
1 24 24
change 4 6 24 e<1
1 16 16
Point method
Income Elasticity
• The income elasticity is defined as a proportional change in quantity

demanded to the percentage change in Income.
• D= f(M)
• Income Elasticity= % change in QD/% change in Income
• = % Q/% M
• M=Income
Cross Elasticity
• The Cross elasticity demand refers to the degree of responsiveness of demand for a commodity
to a given change in the price of some related commodity.
• Cross Elasticity of demand= Proportionate change in demand of X/ Proportionate change in price

of Y
• exy = Qx/ Py* Px/Qx
• Positive elasticity- Substitute goods
• Negative elasticity- Complimentary Goods
• Neutral exy=0 - Unrelated goods
Role of Elasticity of demand in decision-making
• Businesses
• Government
• International trade
• Policy makers
• Trade Unions

Demand Theory

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Demand Theory

(Dx) = f(Px, Ps/Pc, I/Yd, T, A,N, u)

The relationship is known to be ‘inverse’.

It is the tabular arrangement of the demand/price relationship.

Price of Mangoes Quantity demanded

• It shows the aggregate quantity demanded by all the buyers in the

The below formula can represent the linear demand function:

Q1 TO Q2 /Q2 TO Q3- Extension; Q4 TO Q3/Q3TO Q2- Contraction

1) Rise in the income.

Positive relationship ( upward DD curve)

• D = f(P) • D=f(M) • Dx=f(Py),

The elasticity of demand measures responsiveness for demand for a

Q= Q2(New QD)-Q1(Initial QD); P= P2 (New price)- P1(Initial price)

Prices of Apples (Rs.) Quantity Demanded (Kg.)

20 (P/P1) 100 ( QD/Q1)

• Unitary elastic demand e=1

• Also known as the percentage method;

• = change in Q/ quantity(Q)* Price (P)/Change in P

• Total Revenue= Price * Quantity purchases/ sold

• The income elasticity is defined as a proportional change in quantity

• Cross Elasticity of demand= Proportionate change in demand of X/ Proportionate change in price

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