Theory of Demand

Meaning of Demand: The demand for a commodity is the amount of it that a consumer will
purchase or will be ready to take off from the market at various given prices in a period of time such
as a day, week, month or a year. Thus, demand in economics implies both the desire to purchase and
the ability to pay for a good.

Determinants of Demand: The demand of a product is influenced by a number of factors. An

organization should properly understand the relationship between the demand and its each
determinant to analyze and estimate the individual and market demand of a product. The demand
for a product is influenced by various factors, such as price, consumer’s income, and growth of
population.

For example, the demand for apparel changes with change in fashion and tastes and preferences of
consumers. The extent to which these factors influence demand depends on the nature of a product.
An organization, while analyzing the effect of one particular determinant on demand, needs to
assume other determinants to be constant. This is due to the fact that if all the determinants are
allowed to differ simultaneously, then it would be difficult to estimate the extent of change in
demand.

Following are the determinants of demand for a product:

i. Price of a Product or Service:

Price of the commodity affects the demand of a product to a large extent. There is an inverse
relationship between the price of a product and quantity demanded. The demand for a product
decreases with increase in its price, while other factors are constant, and vice versa. For
example, consumers prefer to purchase a product in a large quantity when the price of the
product is less.

ii. Income:

Income constitutes one of the important determinants of demand. The income of a consumer
affects his/her purchasing power, which, in turn, influences the demand for a product. Increase
in the income of a consumer would automatically increase the demand for products by him/her,
while other factors are at constant, and vice versa.

For example, if the salary of Mr. X increases, then he may increase the pocket money of his
children and buy luxury items for his family. This would increase the demand of different
products from a single family. The income-demand relationship can be analyzed by grouping
goods into four categories, namely, essential consumer goods, inferior goods, normal goods, and
luxury goods.

The relationship between the income of a consumer and each of these goods is explained as
follows:

a. Essential or Basic Consumer Goods: Refer to goods that are consumed by all the people in the
society. For example, food grains, soaps, oil, cooking fuel, and clothes. The quantity demanded
for basic consumer goods increases with increase in the income of a consumer, but up to a fixed
limit, while other factors are constant.

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 b. Normal Goods: Refer to goods whose demand increases with increase in the consumer’s
income. For example, goods, such as clothing, vehicles, and food items, are demanded in
relatively increasing quantity with increase in consumer’s income. The demand for normal goods
varies due to different rate of increase in consumers’ income.

c. Inferior Goods: Refer to goods whose demand decreases with increase in the income of
consumers. For example, a consumer would prefer to purchase wheat and rice instead of millet
and cooking gas instead of kerosene, with increase in his/her income. In such a case, millet and
kerosene are inferior goods for the consumer.

However, these two goods can be normal goods for people having lower level of income.
Therefore, we can say that goods are not always inferior or normal; it is the level of income of
consumers and their perception about the need of goods.

d. Luxury Goods: Refer to goods whose demand increases with increase in consumer’s income.
Luxury goods are used for the pleasure and esteem of consumers. For example, expensive
jewellery items, luxury cars, antique paintings and wines, and air travelling.

iii. Tastes and Preferences of Consumers:

Play a major role in influencing the individual and market demand of a product. The tastes and
preferences of consumers are affected due to various factors, such as life styles, customs,
common habits, and change in fashion, standard of living, religious values, age, and sex.

A change in any of these factors leads to change in the tastes and preferences of consumers.
Consequently, consumers reduce the consumption of old products and add new products for
their consumption. For example, if there is change in fashion, consumers would prefer new and
advanced products over old- fashioned products, provided differences in prices are
proportionate to their income.

Apart from this, demand is also influenced by the habits of consumers. For instance, most of the
South Indians are non-vegetarian; therefore, the demand for non- vegetarian products is higher
in Southern India. In addition, sex ratio has a relative impact on the demand for many products.

For instance, if females are large in number as compared to males in a particular area, then the
demand for feminine products, such as make-up kits and cosmetics, would be high in that area.

iv. Price of Related Goods:

Refer to the fact that the demand for a specific product is influenced by the price of related
goods to a greater extent. Related goods can be of two types, namely, substitutes and
complementary goods, which are explained as follows:

a. Substitutes: Refer to goods that satisfy the same need of consumers but at a different price.
For example, tea and coffee, and groundnut oil and sunflower oil are substitute to each other.
The increase in the price of a good results in increase in the demand of its substitute with low
price. Therefore, consumers usually prefer to purchase a substitute, if the price of a particular
good gets increased.

b. Complementary Goods: Refer to goods that are consumed simultaneously or in combination.

In other words, complementary goods are consumed together. For example, pen and ink, car

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 and petrol, and tea and sugar are used together. Therefore, the demand for complementary
goods changes simultaneously. The complementary goods are inversely related to each other.
For example, increase in the prices of petrol would decrease the demand of cars.

v. Expectations of Consumers:

Imply that expectations of consumers about future changes in the price of a product affect the
demand for that product in the short run. For example, if consumers expect that the prices of
petrol would rise in the next week, then the demand of petrol would increase in the present.

On the other hand, consumers would delay the purchase of products whose prices are expected
to be decreased in future, especially in case of non-essential products. Apart from this, if
consumers anticipate an increase in their income, this would result in increase in demand for
certain products. Moreover, the scarcity of specific products in future would also lead to
increase in their demand in present.

vi. Inventions and Innovations:

Inventions and innovations introduce new goods in the market. The consumers will have a
strong tendency to purchase the new product. Introduction of new goods or substitutes as a
result of inventions and innovations in a dynamic modern economy tends to adversely affect the
demand for the existing products.

vii. Distribution of Income in the Society:

Distribution of income in the society influences the demand for a product in the market to a
large extent. If income is equally distributed among people in the society, the demand for
products would be higher than in case of unequal distribution of income. However, the
distribution of income in the society varies widely.

This leads to the high or low consumption of a product by different segments of the society. For
example, the high income segment of the society would prefer luxury goods, while the low
income segment would prefer necessary goods. In such a scenario, demand for luxury goods
would increase in the high income segment, whereas demand for necessity goods would
increase in the low income segment.

viii. No. of Consumers:

No. of consumers is a crucial factor that affect the market demand of a product. If the number of
consumers increases in the market, the consumption capacity of consumers would also increase.
Therefore, high growth of population would result in the increase in the demand for different
products.

ix. Government Policy:

Government policy refers to one of the major factors that affect the demand for a product. For
example, if a product has high tax rate, this would increase the price of the product. This would
result in the decrease in demand for a product. Similarly, the credit policies of a country also
induce the demand for a product. For example, if sufficient amount of credit is available to
consumers, this would increase the demand for products.

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x. Climatic Conditions:

Affect the demand of a product to a greater extent. For example, the demand of ice-creams and
cold drinks increases in summer, while tea and coffee are preferred in winter. Some products
have a stronger demand in hilly areas than in plains. Therefore, individuals demand different
products in different climatic conditions.

The Law of Demand:

The law of demand expresses the functional relationship between price and quantity demanded.
According to the law of demand, “other things being equal, if price of a commodity falls, the quantity
demanded of it will rise and if price of the commodity rises, its quantity demanded will decline.”
Thus according to the law of demand, there is inverse relationship between price and quantity
demanded when other things remaining the same.

Assumptions underlying the law of demand:

 No change in consumer’s income

 No change in consumer’s taste, preferences and habits
 No change in the price of related goods
 No change in future expectations
 No change in the income distribution
 No change in weather conditions
 No change in Technology
 No change in Government policies
 No change in the no. of consumers

An Individual’s Demand Schedule and Curve:

An individual consumer’s demand refers to the quantities of a commodity demanded by him at

various prices, other things remaining equal. An individual’s demand for commodity is shown on the
demand schedule and on the demand curve. A demand schedule is a list of prices and quantities and
its graphic representation is a demand curve.

The demand schedule reveals that when the price is Rs 5, the quantity demanded is 5 units. If the
price happens to be Rs 4, the quantity demanded is 10 units, and ultimately the price being Re.1, 25
units are demanded. In Figure 1. DD1 is the demand curve drawn on the basis of the above demand
schedule.

The dotted points P,Q,R,S and T show the various price-quantity combinations. Marshall Call them
“demand points”. The first combination is represented by the first dot and the remaining price-
quantity combinations move to the right towards D1.

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The Market Demand Schedule and Curve:

In a market, there is not one consumer but many consumers of a commodity. The market demand of
a commodity is depicted on a demand schedule and a demand curve. They show the sum total of
various quantities demanded by all the individuals at various prices. Suppose there are two
individuals A and B in a market who purchase the commodity. The demand schedule for the
commodity is depicted in Table 2.

The Table represents the market demand of orange at various prices. It is arrived at by adding the
demand of consumers A and B.

When the price is very high, Rs 5 per unit, the market demand for orange is 15 units. As the price
falls, the demand increases. When the price is the lowest, Re. 1 per unit, the market demand is 75
units.

From Table 2 we draw the market demand curve in Figure 2. DM is the market demand curve which is
the horizontal summation of the two individual demand curves DA + DB. The market demand for a
commodity depends on all factors that determine an individual’s demand.

But a better way of drawing a market demand curve is to add together sideways (lateral summation)
of all the individual demand curves. In this case, the different quantities demanded by consumers at
one price are represented on each individual demand curve and then a lateral summation is done, as
shown in Figure 3.

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Suppose there are three individuals A, B and C in a market who buy OA, OB and OC quantities of the
commodity at the price OP, as shown in Panels (A), (B) and (C) respectively in Figure 3. In the market,
OQ quantity will be bought which is made up by adding together the quantities OA, OB and OC. The
market demand curve, DM is obtained by the lateral summation of the individual demand curves DA,
DB and DC in panel (D).

Reasons for the Law of Demand: Why does Demand Curve Slope Downward?

It may however be mentioned here that there are two factors due to which quantity demanded
increases when price falls:

(1) Income effect,

(2) Substitution effect.

(1) Income Effect:

When the price of a commodity falls the consumer can buy more quantity of the commodity with his
given income. Or, if he chooses to buy the same amount of quantity as before, some money will be
left with him because he has to spend less on the commodity due to its lower price.

In other words, as a result of fall in the price of a commodity, consumer’s real income or purchasing
power increases. This increase in real income induces the consumer to buy more of that commodity.
This is called income effect of the change in price of the commodity. This is one reason why a
consumer buys more of a commodity when its price falls.

(2) Substitution Effect:

The other important reason why the quantity demanded of a commodity rises as its price falls is the
substitution effect. When price of a commodity falls, it becomes relatively cheaper than other
commodities. This induces the consumer to substitute the commodity whose price has fallen for
other commodities which have now become relatively dearer. As a result of this substitution effect,
the quantity demanded of the commodity, whose price has fallen, rises.

Exceptions to the Law of Demand:

Law of demand is generally believed to be valid in most of the situations. However, some exceptions
to the law of demand have been pointed out.

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Goods having Prestige Value: Veblen Effect:

One exception to the law of demand is associated with the name of the economist, Thorstein Veblen
who propounded the doctrine of conspicuous consumption. According to Veblen, some consumers
measure the utility of a commodity entirely by its price i.e., for them, the greater the price of a
commodity, the greater its utility.

For example, diamonds are considered as prestige good in the society and for the upper strata of the
society the higher the price of diamonds, the higher the prestige value of them and therefore the
greater utility or desirability of them. In this case, some consumers will buy less of the diamonds at a
lower price because with the fall in price its prestige value goes down.

On the other hand, when price of diamonds goes up, their prestige value goes up and therefore their
utility or desirability increases. As a result at a higher price the quantity demanded of diamonds by a
consumer will rise. This is called Veblen effect. Besides diamonds, other goods such as mink coats,
luxury cars have prestige value and Veblen effect works in their case too.

Giffen Goods:

Another exception to the law of demand was pointed out by Sir Robert Giffen who observed that
when price of bread increased, the low-paid British workers in the early 19th century purchased
more bread and not less of it and this is contrary to the law of demand described above. The reason
given for this is that these British workers consumed a diet of mainly bread and when the price of
bread went up they were compelled to spend more on given quantity of bread.

Therefore, they could not afford to purchase as much meat as before. Thus, they substituted even
bread for meat in order to maintain their intake of food. After the name of Robert Giffen, such goods
in whose case there is a direct price-demand relationship are called Giffen goods. It is important to
note that with the rise in the price of a Giffen good, its quantity demand increases and with the fall
in its price its quantity demanded decreases, the demand curve will slope upward to the right and
not downward.

Demand Function:

The demand function is an algebraic expression of the relationship between demand for a com-
modity and its various determinants that affect this quantity.

The market demand function may be expressed mathematically thus:

Dx = f(Px, Pr, Y, T, I, N, G, U)

Where

Dx = Quantity demanded for commodity x

f = functional relation

Px = Price of commodity x

Pr = Prices of related commodities i.e. substitutes and complementaries

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Y = The money income of the consumer

T = The taste, preferences and habits of the consumer

I = Inventions and Innovations

N = The No. of consumers

G = Government policies

U = Unknown or other variables

By demand function, economists mean the entire functional relationship. This means the whole
range of price quantity relationship and not just the quantity demanded at a given price per unit of
time. The demand function expressed above is really just a listing of variables that affect the
demand.

The basic assumption in demand schedule and demand curve has been the relationship between
price and quantity of a commodity signifying a change in price to bring a change in quantity
demanded with all other variables assumed constant and unchanged. According to the law of
demand the demand function is:

Dx = f(Px)

The above functional form does not show how much quantity demanded of a consumer will change
following a unit change in its price. For the purpose of actually estimating demand for a commodity,
we need a specific form of demand function. Generally, demand function is considered to be of a
linear form. The specific demand function of a linear form is written as:

Dx = a – b(Px)

Changes in Demand and Quantity Demanded

In economics the terms change in quantity demanded and change in demand are two different
concepts.

Change in quantity demanded refers to change in the quantity purchased due to increase or
decrease in the price of a product.

In such a case, it is incorrect to say increase or decrease in demand rather it is increase or decrease
in the quantity demanded.

On the other hand, change in demand refers to increase or decrease in demand of a product due to
various determinants of demand, while keeping price at constant.

Changes in quantity demanded can be measured by the movement of demand curve, while changes
in demand are measured by shifts in demand curve. The terms, change in quantity demanded refers
to expansion or contraction of demand, while change in demand means increase or decrease in
demand.

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1. Expansion and Contraction of Demand:

The variations in the quantities demanded of a product with change in its price, while other factors
are at constant, are termed as expansion or contraction of demand. Expansion of demand refers to
the period when quantity demanded is more because of the fall in prices of a product. However,
contraction of demand takes place when the quantity demanded is less due to rise in the price o a
product.

For example, consumers would reduce the consumption of milk in case the prices of milk increases
and vice versa. Expansion and contraction are represented by the movement along the same
demand curve. Movement from one point to another in a downward direction shows the expansion
of demand, while an upward movement demonstrates the contraction of demand.

When the price changes from OP to OP1 and demand moves from OQ to OQ1, it shows the
expansion of demand. However, the movement of price from OP to OP2 and movement of demand
from OQ to OQ2 show the contraction of demand.

2. Increase and Decrease in Demand:

Increase and decrease in demand are referred to change in demand due to changes in various other
factors such as change in income, distribution of income, change in consumer’s tastes and
preferences, change in the price of related goods, while Price factor is kept constant Increase in
demand refers to the rise in demand of a product at a given price.

On the other hand, decrease in demand refers to the fall in demand of a product at a given price. For
example, essential goods, such as salt would be consumed in equal quantity, irrespective of increase
or decrease in its price. Therefore, increase in demand implies that there is an increase in demand
for a product at any price. Similarly, decrease in demand can also be referred as same quantity
demanded at lower price, as the quantity demanded at higher price.

Increase and decrease in demand is represented as the shift in demand curve. In the graphical
representation of demand curve, the shifting of demand is demonstrated as the movement from
one demand curve to another demand curve. In case of increase in demand, the demand curve shifts
to right, while in case of decrease in demand, it shifts to left of the original demand curve.

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In Figure-12, the movement from DD to D1D1 shows the increase in demand with price at constant
(OP). However, the quantity has also increased from OQ to OQ1.

In Figure-13, the movement from DD to D2D2 shows the decrease in demand with price at constant
(OP). However, the quantity has also decreased from OQ to OQ2.

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