Theory of Demand

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 Introduction to Demand
• Demand is a combination of three factors:

1. Desire to buy
2. Willingness to pay the price
3. Ability to pay the price
• Absence of any one factor will not create demand
• Demand- the demand for a commodity is consumer’s desire
to have it for which he is willing and able to pay.
• Law of Demand is called as First Law of Purchase

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 The Law of Demand
 If other things remain constant , price of the commodity
falls the quantity demand of it will rise and if the price of
the commodity rises , its quantity demanded will decline.
 The words, “other things remain constant” are important
• In the real world many variables change simultaneously
• However, in order to understand the economy we must first
understand each variable separately
• Thus we assume that, “other thing remain constant,” in order to
understand how demand reacts to price

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 Derived Demand
• Some goods are not demanded by consumer
to satisfy their wants directly but they are
used to produce other goods which directly
satisfy their wants.
• Eg. Demand for machines, raw material etc.
• Demand for factors of production called
derived demand.

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 The Demand Schedule
• Demand schedule
– A list showing the quantity of a good that consumers would
choose to purchase at different prices, with all other
variables held constant

• Demand V.S. Quantities demanded

- demand is the entire relationship between price and quantity

represented in demand curve

- quantities demanded are specific amount of goods buyers want

to buy
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 The Demand Curve

• The market demand curve (or just demand curve)

shows the relationship between the price of a good and
the quantity demanded , holding constant all other
variables that influence demand
– Each point on the curve shows the total buyers would
choose to buy at a specific price

• Law of demand tells us that demand curves virtually

always slope downward
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Demand and Quantity Demand

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 Figure 1: The Demand Curve
Price per
Bottle

When the price is Rs 10

per bottle, 40,000 bottles
are demanded (point A).
A
Rs 10
At Rs 8 per bottle,
60,000 bottles are
B demanded (point B).
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40,000 60,000 Number of Bottles

per Month

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Movement and Shift in Demand

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Movement along with Demand Curve

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Shift in Demand curve

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 “Change in Quantity Demanded” vs. “Change in Demand”

• Language is important when discussing demand

– “Quantity demanded” means
• A particular amount that buyers would choose to buy at a specific price

• It is a number represented by a single point on a demand curve

• When a change in the price of a good moves us along a demand curve, it

is a change in quantity demand

– The term demand means

• The entire relationship between price and quantity demanded—and
represented by the entire demand curve
• When something other than price changes, causing the entire demand
curve to shift, it is a change in demand
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 Why does demand curve slope downward
to right?

• Law of diminishing marginal utility

• Entry of New consumer
• Income effect
• Substitution effect
• Psychological Effect

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 Income: Factors That Shift The Demand Curve
• An increase in income has effect of shifting demand
for normal goods to the right
– However, a rise in income shifts demand for inferior goods
to the left

• A rise in income will increase the demand for a normal

good, and decrease the demand for an inferior good
• Normal good and inferior good are defined by the
relation between demand and income
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The Impact of a Change in Income
• Higher income decreases the • Higher income increases the
demand for an inferior good demand for a normal good

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 Wealth: Factors That Shift The Demand Curve

• Your wealth—at any point in time—is the total value of

everything you own minus the total dollar amount you owe

- Example

• An increase in wealth will

– Increase demand (shift the curve rightward) for a normal good

– Decrease demand (shift the curve leftward) for an inferior good

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 The Impact of a Change in the Price of
Related Goods
• Demand for complement good
(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
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 Number of buyers
• An increase in the number of potential buyers
will increase the demand for the good.
• For example, the demand for land increases as
the population increases.
• Similarly movie/sports tickets are generally
more expensive in larger cities.
• Air tickets in peak season
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 Future Prices
• An increase in the expected future price of a
good increases current demand.
• A decrease in the expected future price of a
good decreases current demand.
• For example, Onion Prices due to the fear of
shortage.
• Prices of financial assets
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 Tastes & Quality
• Demand curves can shift due to changes in
tastes over time.
• For example, demand for Bajaj Chetak

• Similarly, demand for Honda Activa

• Quality:

• Demand curves can shift due to changes quality.

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 Summary- Factors Affecting Demand
• Income (depends on good’s nature: normal or inferior) [positive
and negative respectively]

• Wealth (depends on good’s nature) [positive and negative

respectively]

• Prices of substitutes (positively related)

• Prices of complements (negatively related)

• Population (positively related)

• Expected price (positively related)

• Tastes (positively related)

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 Figure 3(b): Movements Along and Shifts
of The Demand Curve
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good

D2
D1

Quantity

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Figure 3(c): Movements Along and Shifts of
The Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift away from the
good

D1
D2

Quantity

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 From Household to Market Demand

• Demand for a good or service can be defined

for an individual household, or for a group of
households that make up a market.
• Market demand is the sum of all the
quantities of a good or service demanded per
period by all the households buying in the
market for that good or service.

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 From Household Demand to Market
Demand
• Assuming there are only two households in the
market, market demand is derived as follows:

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 Fitting Linear Demand Equation
A mathematical model can be specified as follows:
𝑄𝐷 = 𝑎 − 𝑏𝑃
where, QD is quantity demanded
a is intercept and
b is slope of the equation
An Econometric model can be specified as follows:
𝑄𝐷 = 𝛼𝑖 − 𝛽𝑖 𝑃+ 𝜀𝑖
where, 𝛼𝑖 is intercept
𝛽𝑖 is slope of the equation and
𝜀𝑖 is the random error term 26
 Data
Price Quantity Demanded

0 800

2 680

4 560

6 440

8 320

10 200

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 Result
• QD= 800- 60P
• A multivariate specification can be estimated
through Ordinary Least Squares (OLS) method
for forecasting purposes

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 Exceptions
• Giffen Paradox: Giffen good is one which people
paradoxically consume more as the price rises and
consume less when price falls, violating the law of
demand.

• Example: in 19th century England, price of bread increased

due to nationwide famine but demand saw an increasing
trend.

• This was due to the reduced consumption of other

products and diverting the resources to bread. 29
• Veblen Effect (Conspicuous Consumption): Goods/services
having prestige value or status symbol, law of demand does
not apply.
• Speculative Effect: Law of demand does not apply to
speculative market. For e.g. shares, debentures etc. (i.e.
momentum investing based on algorithm trading, short
selling)
• Economic Fluctuations: Law of Demand do not operate
during Inflation due to shortage of goods/services or due to
increased money supply
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