Theory of demand

Definition of Demand
• Desire backed by purchasing power.
 Law of demand
Other things remaining constant, as the price of
a good increases quantity demanded
decreases; conversely, as the price of a good
decreases quantity demanded increases.
 In other words, the law of demand describes
an inverse relationship between price and
quantity demanded of a good.
 Determinants of demand
• The price of the goods or service.
• Prices of related goods or services.
• Income of buyers.
• Tastes and preferences of consumers.
• Expectations regarding price change in near
future.
 Exceptions to the law of demand

Other things remaining constant, as the price of

a good increases quantity demanded
increases; conversely, as the price of a good
decreases quantity demanded decreases.
 In other words, the exception to law of demand
describes a direct relationship between price
and quantity demanded of a good.
• Exception is applicable to Veblen
goods and Giffen goods.
• Veblen goods – Propounded by American
economist Thorstein Veblen.
• Giffen goods -   Propounded by Scottish
economist Sir Robert Giffen.
 Veblen goods
• These are types of luxury goods for which the
quantity demanded increases as the price
increases, an apparent contradiction of the law of
demand.
• Consumers actually prefer more of the good as its
price rises, and the result is an upward sloping
demand curve. For example, in the 1990s when
"fashion" jeans became popular, one retailer found
that he could sell more when he raised the price.
• Also functioning as positional goods, they
include expensive wines, jewelry, fashion-
designer handbags, and luxury cars which are
in demand because of, rather than in spite of,
the high prices asked for them.
• This makes them desirable as status
symbols in the practices of conspicuous
consumption and conspicuous leisure.
 Giffen goods
• A Giffen good describes an inferior good that
as the price increases, demand for the product
increases.
• As an example, during the Irish Potato
Famine of the 19th century, potatoes were
considered a Giffen good.
• Potatoes were the largest staple in the Irish
diet, so as the price rose it had a large impact
on income. People responded by cutting out
on luxury goods such as meat and vegetables,
and instead bought more potatoes.
• Therefore, as the price of potatoes increased,
so did the quantity demanded
Theory of Supply
Other things remaining constant, as the price of
a good increases quantity supplied increases;
conversely, as the price of a good decreases
quantity supplied decreases.
 In other words, the law of supply describes a
direct relationship between price and
quantity supplied of a good.
 Determinants of supply
• Number of Sellers.
• Prices of Resources.
• Taxes and Subsidies.
• Technology.
• Suppliers' Expectations.
• Prices of Related Products.
• Prices of Joint Products.
Elasticity of Demand
• Price elasticity of demand
• Income elasticity of demand
• Cross elasticity of demand
 Price elasticity of demand (PED)

• It measures the percentage change in quantity

demanded due to percentage change in price.
• Price elasticities are negative in general.
Price elasticity is of 2 types –
Arc elasticity (also called Mid-point formula)
Point elasticity (using calculus)
 Nature of Elasticity
• Elastic
• Inelastic
• Unitary elastic
• Infinitely elastic
• Completely inelastic
 Determinants of PED
• Availability of substitute goods
• Percentage of income spent on that good
• Necessity
• Breadth of usage
• Duration of price change
• Brand loyalty
• Who pays the price
• Addiction
 Importance of PED
• International trade
• Formulation of Government Policies
• Factor Pricing
• Decisions of Monopolist
• Paradox of poverty amidst plenty
Income elasticity of demand (IED)
• It measures the responsiveness of the
quantity demanded for a good or service to a
change in the income of the people
demanding the good.
• It is calculated as the ratio of the percentage
change in quantity demanded to the
percentage change in income.
 Interpretation of IED
• A negative income elasticity of demand is
associated with inferior goods; an increase in
income will lead to a fall in the demand and
may lead to changes to more luxurious
substitutes.
• A positive income elasticity of demand is
associated with normal goods; an increase in
income will lead to a rise in demand.
• If income elasticity of demand of a commodity
is less than 1, it is a necessity good. If the
elasticity of demand is greater than 1, it is
a luxury good or a superior good.
• A zero income elasticity of demand occurs
when an increase in income is not associated
with a change in the demand of a good.
Income elasticity of demand can be used as an
indicator of
• industry health,
• future consumption patterns
• as a guide to firms’ investment decisions
 Cross elasticity of demand

• It measures the responsiveness of the

quantity demanded for a good to a change in
the price of another good, ceteris paribus.
• It is measured as the percentage change in
quantity demanded for the first good that
occurs in response to a percentage change in
price of the second good.
 Relation between Revenue & Elasticity

• The total revenue test is a means for

determining whether demand is elastic or
inelastic.
• If an increase in price causes an increase in
total revenue, then demand can be said to be
inelastic, since the increase in price does not
have a large impact on quantity demanded.
 Arc elasticity

PED = (P1 + P2)/2 X change in price

(Q1 + Q2)/2 change in quantity
Use the demand curve diagram below to
answer the following TWO questions
1. What is the own-price elasticity of demand as
price decreases from $8 per unit to $6 per
unit? Use the mid-point formula in your
calculation.
a) Infinity
b) 7.0
c) 2.0
d) 1.75
2. What is the own-price elasticity of demand as
price decreases from $4 per unit to $2 per
unit? Use the mid-point formula in your
calculation.
a) 0
b) 3.3
c) 0.3
d) 1.3