THEORY OF DEMAND AND SUPPLY

UNIT 1: LAW OF DEMAND AND ELASTICITY OF DEMAND

DEMAND- MEANING
 Refers to the quantity of a good or a service that buyers are willing and able to
purchase at various prices during a given period of time.
 Effective demand depends on:
i. Desire
ii. Means to purchase
iii. Willingness to use those means for that purchase
 Quantity demanded is always expressed at a given price.
 Quantity demanded is a flow.

DETERMINANTS OF DEMAND
i. Price of the commodity- Price rises, quantity demanded falls and vice- versa.
ii. Price of related commodities-
a. Complementary Goods- Goods that are bought or consumed together or
simultaneously. Eg: pen and ink, car and petrol. Increase in demand for one
good due to fall in price of that good causes increase in demand for the other
good and vice- versa. Thus, there is an inverse relationship between demand
for a good and price of its complement.
b. Substitute/Competing Goods- Goods that satisfy the same want and can be
used in place of each other. Eg: Different brands of tea, toothpaste etc. If the
price of a product goes up, the buyers can easily switch to the substitute
product. This decreases the demand for the product and increases the demand
for the substitute. Thus, there is a direct relationship between demand for a
product and price of its substitute.
iii. Disposable income of the consumer- The purchasing power of a consumer
depends upon his disposable income. All else being equal, the demand for a
commodity depends upon the disposable income of the potential purchasers. An
increase in disposable income increases demand for certain types of goods and
services at any given price and vice- versa. The different types of goods are as
follows:
a. Normal goods- Those that are demanded in increasing quantities as
consumers’ income increases.
b. Inferior goods- Demand for such goods decreases as income increases beyond
a certain level.
c. Essential goods- Increase in income causes a less than proportionate increase
in demand.
d. Luxury goods- Increase in income beyond a certain level causes increase in
demand, which keeps increasing as income rises.
iv. Tastes and preferences of buyers- Goods which are more in trend are demanded in
increased quantities at a given point of time. Goods which are perceived as
obsolete and out of fashion face decreased demand. External effects on utility
such as ‘demonstration effect’, ‘bandwagon effect’, ‘Veblen effect’ and ‘snob
effect’ also play an important part in determining the demand for a product.
a. Demonstration effect- Coined by James Duesenberry. Refers to the desire of
people to emulate the consumption behaviour of others.
b. Bandwagon effect- Refers to the extent to which the demand for a commodity
is increased due to the fact that others are also consuming the same
commodity.
c. Snob effect- Extent to which demand for a good is decreased owing to the fact
that others are also consuming it. Represents desire for exclusivity and being
different.
d. Veblen effect- Named after American economist Thorstein Veblen. Refers to
the desire of status seeking rich people to consume high priced luxury goods.
Difference between snob and Veblen effect- Snob effect is a function of
consumption of goods by others, whereas Veblen effect is a function of the
price.

v. Consumers’ Expectations
Consumers’ expectations regarding future prices, income, supply conditions etc,
affect future demand. If the consumers expect increase in future prices, increase in
income or shortages in supply, more quantities will be demanded. If they expect a
fall in price, income or supply in the future, current demand will fall.

vi. Other factors:

a. Size of population- Larger the size of population of a country, higher will be
the demand and vice versa.
b. Age distribution of population- The demand for goods and services depends
on the age distribution of the population consuming it. Eg: If the population
consists mainly of aged people, the demand for healthcare services will
generally be higher and demand for children’s books will be lower.
c. Level of National Income and its distribution- Higher the national income of a
nation, greater will be the level of demand. Similarly, if the distribution of
income is equal, the consumption of the country as a whole will be generally
high, indicating higher demand for goods.
d. Consumer credit facility and interest rates- Availability of credit facilities
induces people to consume more than their income levels. Demand for
investment and expensive goods will increase if credit facilities are available.
Similarly, lower interest rates encourage people to borrow more, thereby
leading to increased demand.
e. Government policies and regulations- Governments influence demand through
its taxation, expenditure, purchases and subsidy policies. Taxes increase prices
and decrease demand, while subsidies decrease prices and increase demand.
THE DEMAND FUNCTION
The demand function states the relationship between the demand for a good and its
determinants. Any other factors which are not explicitly stated in the demand function are
assumed to be constant or irrelevant. The demand function may be expressed as follows:
Qx= f (Px, Y, Pr)
Qx= Quantity demanded of Product X
Px= Price of the commodity
Y= money income of the consumer
Pr= Price of related goods

THE LAW OF DEMAND

 The law of demand states that, other things being equal, when the price of the good
rises, the quantity demanded of the good will fall.
 Thus, there is an inverse relationship between the price and quantity demanded,
ceterus paribus.
 The all other things that remain equal are price of related goods, income of
consumers, tastes and preferences etc. i.e., everything other than own price of the
commodity.

Demand Schedule and Demand Curve

Price per cup of ice-cream Quantity of ice-cream demanded(per week)

(in ₹) (Cups)
A 60 0
B 50 2
C 40 4
D 30 6
E 20 8
F 10 10
G 0 12
Points to be noted about the demand curve:
i. It shows the relationship between the quantities of a good that buyers are willing
to buy and the price of the good.
ii. The negative or downward slope indicates that the quantity demanded increases as
the price falls. Consumers are usually ready to buy more if the price is lower.
iii. The downward sloping demand curve is in accordance with the law of demand
which describes an inverse price-demand relationship.
iv. The slope of a demand curve is - ∆P/∆Q.
v. The negative sign of this slope is consistent with the law of demand.
vi. The demand curve for a good does not have to be linear or a straight line; it can be
curvilinear.

MARKET DEMAND SCHEDULE AND CURVE

Quantity demanded by
Price of Good X in (₹) A B Total Market Demand
0 3 2 5
10 2 1 3
20 1 0 1
30 0 0 0
The straight-line demand curve where we hold everything else constant is described by a
linear demand function. We can write a demand function as follows:
Q = a – bP

Where ‘a’ is the vertical intercept and ‘b’ is the slope.

RATIONALE OF THE LAW OF DEMAND

Normally, the demand curve slopes downwards. The following are the reasons for the
downward sloping demand curve:
1. Price Effect of a fall in price: The price effect which indicates the way the
consumer's purchases of good X change, when its price changes, is the sum of its two
components namely: substitution effect and income effect.
i. Substitution effect:
 Hicks and Allen have explained the law in terms of substitution effect
and income effect. The substitution effect describes the change in
demand for a product when its relative price changes. When the price
of a commodity falls, it becomes relatively cheaper than other
commodities.
 Assuming that the prices of all other commodities remain constant, it
induces consumers to substitute the commodity whose price has fallen
for other commodities which have now become relatively expensive.
 The result is that the total demand for the commodity whose price has
fallen increases. This is called substitution effect.
 The substitution effect will be stronger when:
a) The goods are closer substitutes
b) There is lower cost of switching to the substitute good
c) There is lower inconvenience while switching to the substitute
good
ii. Income effect:
 The increase in demand on account of an increase in real income is
known as income effect. When the price of a commodity falls, the
consumer can buy the same quantity of the commodity with lesser
money or he can buy more of the same commodity with the same
amount of money. As a result of fall in the price of the commodity,
consumer’s real income or purchasing power increases. Therefore, the
demand for that commodity (whose price has fallen) increases.
 However, there is one exception. In the case of inferior goods, the
income effect works in the opposite direction to the substitution effect.
In the case of inferior goods, the expansion in demand due to a price
fall will take place only if the substitution effect outweighs the income
effect.

iii. Utility maximising behaviour of Consumers:

 A consumer is in equilibrium (i.e. maximises his satisfaction) when the
marginal utility of the commodity and its price equalize. The consumer
has diminishing utility for each additional unit of a commodity and
therefore, he will be willing to pay only less for each additional unit.
 A rational consumer will not pay more for lesser satisfaction. He is
induced to buy additional units only when the prices are lower.
 The operation of diminishing marginal utility and the act of the
consumer to equalize the utility of the commodity with its price result
in a downward sloping demand curve.

iv. Arrival of new consumers: When the price of a commodity

falls, more consumers start buying it because some of those who
could not afford to buy it earlier may now be able to buy it. This
raises the number of consumers of a commodity at a lower price
and hence the demand for the commodity in question increases.

v. Different uses: Many commodities have multiple uses. When the price of
such commodities are high (or rises) they will be put to limited uses only. If
the prices of such commodities fall, they will be put to more number of uses
and therefore their demand will increase. Thus, the increase in the number of
uses consequent to a fall in price make the buyer demand more of such
commodities making the demand curve slope downwards. For example:
Electricity
EXCEPTIONS TO THE LAW OF DEMAND
The law of demand is valid in most cases; however there are certain cases where
this law does not hold good. The following are the important exceptions to the
law of demand.
i. Conspicuous goods: Articles of prestige value or snob appeal or articles
of conspicuous consumption are used by the rich people as status symbol
for enhancing their social prestige or /and for displaying wealth. These
articles will not conform to the usual law of demand as they become
more attractive only if their prices are high or keep going up. This was
found out by Veblen in his doctrine of “Conspicuous Consumption”
and hence this effect is called Veblen effect or prestige goods effect.
ii. Giffen goods: Goods which exhibit direct price-demand relationship are
called ‘Giffen goods’. Generally those goods which are inferior, with no
close substitutes available and which occupy a substantial place in
consumers’ budget are called ‘Giffen goods’. All Giffen goods are
inferior goods; but all inferior goods are not Giffen goods.
iii. Conspicuous necessities: The demand for certain goods is affected by
the demonstration effect of the consumption pattern of a social group to
which an individual belongs. These goods, due to their constant usage,
become necessities of life. Hence, their demand does not decrease with
increase in price. Eg: air conditioners.
iv. Future expectations about prices: It has been observed that when the
prices are rising, households, expecting that the prices in the future will
be even higher, tend to buy larger quantities of such commodities. For
example, when there is wide-spread drought, people expect that prices of
food grains would rise in future. They demand greater quantities of food
grains even as their price rises.
v. Incomplete information and irrational behaviour: The law has been
derived assuming consumers to be rational and knowledgeable about
market-conditions. However, at times, consumers have incomplete
information and therefore make inconsistent decisions regarding
purchases. Under such circumstances, the law will not remain valid.
vi. Demand for necessaries: The law of demand does not apply much in
the case of necessaries of life. Irrespective of price changes, people have
to consume the minimum quantities of necessary commodities.
vii. Speculative goods: In the speculative market, particularly in the market
for stocks and shares, more will be demanded when the prices are rising
and less will be demanded when prices decline.
EXPANSION AND CONTRACTION OF DEMAND

 When there is increase in demand due to decrease in price, we say there is expansion
of demand
 When there is decrease in demand due to increase in price, we say there is contraction
of demand.
 Expansion and contraction are also called “Movements along demand curve.

INCREASE AND DECREASE IN DEMAND

 When demand increases due to changes in factors other than own

price of the commodity, we call it an increase in demand.
 When demand decreases due to changes in factors other than
own price of the commodity, we call it a decrease in demand.
 Increase and decrease in demand is also called shifts in demand
curve. While an increase in demand causes a rightward shift in
demand curve, a decrease in demand causes a leftward shift in
demand curve.
 ELASTICITY OF DEMAND

 Elasticity of demand is defined as the degree of responsiveness of the

quantity demanded of a good to changes in one of the variables on which
demand depends.
 It is the percentage change in quantity demanded divided by the
percentage change in one of the variables on which demand depends.
 There are different measures of elasticity such as:
i. Price elasticity
ii. Cross elasticity
iii. Income elasticity
iv. Advertisement elasticity
v. Elasticity of substitution

PRICE ELASTICITY OF DEMAND

 It measures the sensitivity of quantity demanded to ‘own price’ or the
price of the good itself.
 The concept of price elasticity of demand is important for a firm for two
reasons.
i. Knowledge of the nature and degree of price elasticity allows
firms to predict the impact of price changes on its sales.
ii. Price elasticity guides the firm’s profit-maximizing pricing
decisions.
 Price elasticity of demand expresses the degree of responsiveness of
quantity demanded of a good to a change in its price.
 It is measured as the percentage change in quantity demanded divided by
the percentage change in price, other things remaining equal.

% change in quantity demanded

Price Elasticity=Ep= -
% change in Price
 Ep= Change in quantity ×100
( -) Original Quantity
Change in Price×100
Original Price

OR Ep= (-) Change in quantity × Original Price

Original Quantity Change in price

In symbolic terms,
Ep= - ΔQ x P
Q ΔP

Points to note:
i. A negative sign on the elasticity of demand illustrates the law of
demand: less quantity is demanded as the price rises.
ii. The greater the value of elasticity, the more sensitive quantity demanded
is to price.
iii. The value of price elasticity varies from minus infinity to approach zero
i.e., (-∞<Ep<0).
iv. While interpreting the coefficient of price elasticity, we consider only
the magnitude of the price elasticity i.e., its absolute size. For example,
if Ep= -1.22, we say that the elasticity is 1.22 in magnitude.

POINT ELASTICITY OF DEMAND

 Price elasticity of demand at a particular point on the demand curve.
 Used to measure price elasticity, where change in price is infinitesimal.
 Makes use of derivative rather than finite changes in price and quantity.

–dq p
Ed = ×
dp q
GEOMETRIC METHOD

RT = lower segment
Rt upper segment

ARC- ELASTICITY
 Ep= Q2-Q1
(Q2+Q1)/2
P2-P1
(P2+P1)/2
Ep= Q2-Q1 x P2+P1
Q2+Q1 P2-P1

INTERPRETATION OF NUMERICAL VALUES OF ELASTICITY OF DEMAND

 Numerical measure of Verbal description Terminology
elasticity
Zero Quantity demanded does not Perfectly (or
change as price changes completely) inelastic
Greater than zero, but Quantity demanded changes by Inelastic
less than one a smaller percentage than does
price
One Quantity demanded changes by Unit elasticity
exactly the same percentage as
does price
Greater than one, but Quantity demanded changes by a Elastic
less than infinity larger percentage than does price

Infinity Purchasers are prepared to buy Perfectly(or infinitely)

Perfectly
all they can obtain at some price elastic
and none at all at an even
slightly higher price

TOTAL OUTLAY METHOD

Demand
Elastic Unitary Elastic Inelastic
Price increase TO Decreases TO remains same TO Increases
Price decrease TO Increases TO remains same TO Decreases

TOTAL REVENUE
 Demand
Elastic Unitary Elastic Inelastic
Price increase TR Decreases TR remains same TR Increases
Price decrease TR Increases TR remains same TR Decreases

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

1. Availability of substitutes- Goods which typically have close or perfect substitutes
have highly elastic demand curves, since they can be easily substituted with the
cheaper goods.
2. Position of the commodity in the consumer’s budget- The greater the proportion of
income spent on a commodity; generally the greater will be its elasticity of demand
and vice-versa.
3. Nature of the need that the commodity satisfies- Luxury goods are price elastic while
necessities are price inelastic.
4. Number of uses to which the commodity can be put- The more the possible uses of a
commodity, the greater will be its price elasticity and vice versa.
5. Time period- The longer the time period, the more elastic the demand and vice- versa.
6. Consumer habits- If the consumer is habituated to the consumption of a commodity,
the demand will be inelastic and vice- versa.
7. Tied demand- The demand for those goods which are tied to others is normally
inelastic as against those whose demand is of autonomous nature.
8. Price range- Goods which are in very high price range or in very low price range have
inelastic demand, but those in the middle range have elastic demand.
9. Minor complementary items- The demand for cheap, complementary items to be used
together with a costlier product will tend to have an inelastic demand.

INCOME ELASTICITY OF DEMAND

 It is a measure of how much the demand for a good is affected by changes in
consumers’ incomes.

Ei= Percentage change in demand

Percentage change in income

Ei= ΔQ ΔY
÷
Q Y
= ΔQ Y
x
Q ΔY
 INCOME ELASTICITY INTERPRETATION NATURE OF GOOD
Ei < 0 Quantity decreases when income Inferior good
increases.
Ei= 0 Demand is unresponsive to
change in income
Ei > 0 Quantity increases when income Normal goods
increases.
Ei = 1 The percentage change in
quantity demanded is equal to
percentage change in income
Ei < 1 Quantity demanded does not Necessities
show a significant change in
response to income.
Ei > 1 Quantity demanded shows a Luxury goods
significant change in response to
income.

CROSS-PRICE ELASTICITY OF DEMAND

 Cross demand refers to the quantities of a commodity or service which will be
purchased with reference to changes in price of related commodities, other things
remaining the same.

Ec= Percentage change in quantity demanded of Good X

Percentage change in price of Good Y

ΔQx x Py
Ec=
Qx ΔPy

i. Substitute goods

o Upward sloping demand curve, i.e., demand for a commodity will increase when
price of its substitute rises.
o Eg: If tea is the commodity in question, when the price of its substitute coffee
rises, the demand for tea will increase.
o When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive: a rise in the price of Y increases the demand for X and causes a
rightward shift of the demand curve.
i. If two goods are perfect substitutes for each other, the cross
elasticity between them is infinite.
ii. If two goods are close substitutes, the cross-price elasticity
 will be positive and large.
iii. If two goods are not close substitutes, the cross-price
elasticity will be positive and small.
iv. If two goods are totally unrelated, the cross-price elasticity
between them is zero.

ii. Complementary goods

o If price of a commodity increases, the demand for its complementary good

decreases.
o Eg: If the price of pen increases, the demand for ink decreases.
o When two goods are complementary to each other, the cross elasticity between
them is negative so that a rise in the price of one leads to a fall in the quantity
demanded of the other causing a leftward shift of the demand curve.

ADVERTISEMENT ELASTICTY
 Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in the firm’s spending on advertising.
 It measures the percentage change in demand that occurs given a one percent change
in advertising expenditure.

Ea= Percentage change in quantity demanded

Percentage change in advertisement expenditure

ΔQx x A
Ea=
Qx ΔA
Elasticity Interpretation
Ea =0 Demand does not respond at all to increase in advertisement expenditure

Ea>0but<1 Increase in demand is less than proportionate to the increase in

advertisement expenditure
Ea= 1 Demand increase in the same proportion in which advertisement
expenditure increase
Ea>1 Demand increase at a higher rate than increase in advertisement
expenditure