Module 2

Demand theory
Demand (Meaning)

Demand is the desire backed by the ability and willingness to pay for a commodity. It is
always linked with place, price and period.

Demand (Definition)

Prof. Hibdon says “demand means the various quantities of goods that would be purchased
per time period at different prices in a given market”.

Demand for a commodity

Refers to the quantity of commodity demanded in the market in a given period of time at a
given price. Generally, at a lower price more will be demanded and at a higher price less will
be demanded.

Demand Function

The functional relationship between demand for a commodity and the factors determining
demand is called demand function. This can be expressed as:

Dn = f(Pn, Ps, Y, T etc.)

where Dn = demand for a commodity n

f = function of,

Pn = Price of commodity n,

Ps = Price of related commodities,

Y = Income of the individual,

T = Tastes and preferences of individual.

Law of Demand

The relationship between price and quantity demanded is usually referred to as Law of
demand. The law of demand states that, other things being equal, the quantity demanded for a
commodity varies inversely with its price. That is, when price rises, demand for a commodity
falls and when the price falls, demand for a commodity rises.
Assumptions of the Law of demand

1. Income of consumers remains constant.

2. Prices of related commodities (complimentary & substitute goods) remain unchanged.
3. Tastes and preferences of consumers remains same.
4. No further change in price of the commodity is expected.
5. The commodity is a normal commodity.

(The law of demand can be true only when all the assumptions are valid)

Why Demand Curve Slope Downward?

Demand curve slopes downward from left to right indicating that more will be demanded at
lower price and less at higher price.

Following are the main causes which are responsible for downward slopping of demand
curve.

1. Effect of law of diminishing marginal utility:

It is true that satisfaction derived from the consumption of successive units goes on
falling. That is, when a consumer buys more and more units of a commodity, the
marginal utility declines. Therefore, the consumer will buy additional units of a
commodity, only when its price falls.
2. Change in number of consumers:
When the price of a commodity falls, its consumption is spread across more
consumers. Hence the number of consumers and demand for a commodity also rises.
Similarly, if price increases, there will only be less consumers and accordingly
demand falls.
3. Different uses of a commodity:
Most of the commodities can be put to several uses due to which demand curve slopes
downward from left to right. When price of such commodity is high, its use will be
restricted to that purpose which is considered to be most important by the consumer.
On the other hand, if the price of a commodity falls, it can be put to less important
uses as well.
4. Price effect:
Remaining the prices of other goods constant, when the price of a particular
commodity falls, some new customers are attracted towards the commodity and some
 old customers starts to purchase more of the commodity. When the price increases,
new customers withdraw and old customers start consuming lesser commodity.

5. Income effect:
A change in price of a commodity affects the real income of the consumers. When
price falls, real income of the consumer increases which will induce them to buy more
commodities. This is called income effect.
6. Substitution effect:
When the price of a commodity falls, it becomes cheaper in comparison to other
commodities. Then the consumers start to substitute costly commodities with cheaper
commodities. This is called substitution effect.

Exemptions to the law of demand

1. Inferior Goods or Giffen Goods
The law of demand does not operate in the case of certain goods. Sir Robert
Giffen observed that when price of certain commodity increases, demand also
increases and vice versa. These are special kinds of inferior goods, often refereed
as ‘Giffen goods’. As a result, a Giffen good has an upward-sloping demand
curve, which is in violation of the fundamental law of demand. Bread, rice, and
wheat are the best examples of Giffen goods.
Characteristics of Giffen Goods
Consumed mainly by people with low income.
Major part of poor man’s income must be spent on that commodity.
Must not have any substitute or close substitute.
2. Status or Prestige goods
Possession of goods like diamond, gold, rare paintings etc. enhances social status.
People buy them because of their high value. If their prices come down, they will
lose the prestige value and the rich people will reduce the purchase of these goods.
An American economists Mr. T. Veblen classifies the consumption of prestige
goods as “conspicuous consumption”. The demand for these goods increases as
price increases. This phenomenon is known as “Veblen Effect”.
3. Anticipation regarding changes in price
When price rise, consumers may expect a further rise and start buying more and
when price falls they may postpone buying expecting a further fall. This is quite
true in the case of stock exchange transactions.
 4. Depression
In the time of depression, the prices of commodities will be very low and the
demand for them also will be less. This is because of the poor purchasing power
of the people.
5. Change in fashion
If a commodity goes out of fashion, its demand will fall even though its price is
low.
6. Brand loyalty
If a consumer has strong brand preferences, they will stick on to that even when
price increases. For eg: A person who uses and prefers iPhone, will keep on
demanding the same even if price is very high.
7. Emergencies
The law of demand is not applicable during the period of emergencies like war,
flood, drought etc. As the people will be scared about the future availability of
goods, they may stock more even when the price goes up.
8. Ignorance
People buying products even when it is expensive
9. Demand for necessities
10. Weather / climate
11. Special occasions

Determinants of Demand
The demand for a product is influenced by many factors. These factors are known as
“determinants of demand”. The important factors that influence demand are listed below;

1. Price of a product
 Price has a dominant role in shaping the demand for a product. The law of demand
justifies that there is an inverse relationship between price and quantity demanded,
i.e., decrease in price extends demand and increase in price contracts demand. A
fall in price encourages more consumption whereas a rise in price induces existing
consumers to go for substitutes.
2. Income of the consumer
Purchasing power of consumers depends upon their income. It is the income that
decides the type and quantity of goods to be purchased. When the income of a
person rises he may go for quality goods. On the other hand if the income falls,
consumers prefer inferior goods. The demand for normal goods increases with the
increase in income and vice versa. It means that the relationship between demand
for normal goods and the income of consumer is positive. But in the case of
inferior goods the relationship between demand and income is negative.
3. Price of related goods
Related goods are substitute goods and complimentary goods. The goods which
can replace each other in use are substitute goods. For eg: tea and coffee, fish and
meat etc. When the price of a commodity increases, the demand for a substitute
commodity goes up and the relationship is direct in nature.
Complimentary goods are those which are jointly used. For Eg: Bread and butter,
car and petrol, pen and ink etc. In the case of complimentary goods, increase in
price of one commodity reduces the demand for the other. Therefore, the price
demand relationship of complimentary goods is negative.
4. Advertisement Effect
It plays a major role in influencing demand. Expansion of demand is often directly
linked with the expenditure incurred on advertisement. Advertisement attracts new
customers to the product and encourages existing consumers to purchase more.
5. Demonstration effect
It refers to the change in demand for a product due to the change in the
consumption habit of the consumers. Many time the spending habit of the families
may depend upon the tastes of their neighbours also. That means, people try to
imitate consumption pattern of their neighbours. Similarly, there is a tendency of
developing countries to imitate the consumption pattern of people in developed
countries. The increased demand for tinned and fast food in developing countries
is an outcome of demonstration effect.
6. Tastes and preferences of the consumers
 Fashion, habit and customs create tastes and preferences for the product.
Advertisements help to change the tastes and preferences of the customers for a
product. When the product goes out of fashion, its demand decreases even when
the price remains the same.

7. Expectations of the consumer

Consumer expectation regarding the likely change in price of a commodity
influence the demand condition. The expectation regarding increase in the price of
a commodity induces people to buy more. Similarly, they will postpone purchases
when they expect a fall in the price.
8. Population
Nature and composition of population also affects demand. The demand for a
commodity will be more in a country with vast population when compared with
less populated country. For eg: A country with more female population often
places high demand for those feminine products than others.
9. Weather
Certain things like woollen clothes and umbrella are for seasonal use. They are
used according to weather conditions and hence are called seasonal goods. During
cold season, people prefer more woollen clothes and hence the demand will be
high. Similarly, the demand for umbrella will be in its peak during raining season
and dull during off season.
10. Change in the volume of money in circulation
When the money circulation in the society increases, the purchasing power of the
people also increases. This will result in a general increase in demand. Likewise, a
reduction in money supply reduces demand.
11. Consumer credit facility
If the consumers can get credit facility from the seller, banks etc. they will buy
more. Credit facility mostly affects the demand of costly durable goods.
12. Government Policy
The policy of Government with regard to taxes and subsidies also affects demand
as it has some effects on the price of the products and purchasing power of the
people. Imposition of more taxes affects the purchasing power of people leading
to a lesser demand. On then other end, if the Government grants subsidies of
certain products, their price falls and hence demand rises.
Types of Demand

1. Individual demand and market demand

Individual demand: It is quantity of commodity that an individual consumer is willing to

purchase at various prices during a particular period of time. It is the demand placed by a
single household and also known as household demand.

Market demand: It is the quantity of commodity that ‘all households’ are willing to
purchase at various prices during a particular period of time.

2. Ex- ante demand and Ex-post demand

Ex- ante demand: It refers to the amount of goods that the consumers are planning or
intend to buy during a particular period of time. Its basically a planned or desired
demand.

Ex-post demand: It refers to the amount of goods that the consumers actually purchase
during a particular period of time. And it is actual demand where the goods are already
bought by consumers.

3. Joint demand and composite demand

Joint demand: Demand for two or more goods which are used jointly or demanded
together for the satisfaction of one want.

For eg: Car and petrol, milk and sugar

Composite demand: Demand for goods that have multiple uses.

Eg: Electricity (lighting, heating, cooking etc.)

4. Direct Demand and Indirect or Derived demand

Direct demand: The demand for a commodity which directly satisfies wants of the
consumer is called direct demand. All finished goods or consumption goods have direct
demand for eg: demand for food, clothes etc.

Derived Demand: Derived demand occurs when there is a demand for a good or factor of
production resulting from demand for an intermediate good or service. Example –
mobile phones and lithium batteries

The rise in demand for mobile phones and other mobile devices has led to a strong rise in
demand for lithium. Lithium is used in the batteries.