1. Unit-2
Theory of Demand

2. Theory of Demand
If necessity is the mother
of invention, then demand
is the mother of
production.

3. Leon Walras (1834-1910) a French economist,
gave demand theory as a fundamental principle
of microeconomics which gives the analysis of
the relationship between the demand for goods
or services and prices or incomes.
The theory was subsequently developed by
English economist Alfred Marshall (1842-1924),
Italian Vilfredo Pareto (1848-1923), Soviet Eugen
Slutsky (1880-1948), American Kenneth Arrow
(1921- ) and the French-born Gerard Debreu
(1921- ).
-economyprofessor.com
3

4. 4

5. Demand is the basis of all productive activities. Demand
theory is an economic theory that concerns the
relationship between the demand for goods and their
prices; it forms the core of microeconomics.
Demand theory examines purchasing decisions of
consumers and the subsequent impact on prices.
The generation of demand can be pictorially shown
as below,
NEED WANT DEMAND
5

6. Concept of effective demand
Demand in economics means effective demand, which can be
defined as a desire backed by willingness and ability to pay for a
particular product. Thus for demand to effective three factors
are important.
Want Demand
6

7. Demand
Law of Demand Hedonic theory
The law of demand is
normally depicted as
It is an economic
an inverse relation of
quantity demanded theory that the
and price: the higher price an individual
the price of the will pay for a good
product, the less the reflects the sum of
consumer will
the characteristics
demand, ceteris
paribus ("all other of that good.
things being equal").
7

8. Law of Demand
 The quantity purchased of a good or
service is inversely related to the
price, all other things being equal
(ceteris paribus)
8

9. The Law of Demand
 Price changes lead to Price
qty demanded
changing.......
 Represented by A
movements along 3
demand curve. B
negative slope
 Inverse relationship 2
between price and
quantity demanded DD
gives rise to a
downward- sloping
demand curve. 5 15 Quantity/wk
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10.  Demand can be perceived from an
Individual demand market point of
view:
 Individual demand:
 The quantity of a good or service that an
individual or firm stands ready to buy at
various prices at a given time
 Market demand
 The sum of the individual demands in
the marketplace
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11. Determinants of Demand
• Income of the consumer: Consumption is influenced by the
income of a consumer. With every increase in the income of a
consumer , his consumption pattern changes i.e, the purchasing
power of the consumer increases. On the other hand any increase
in the prices of product reduces the purchasing power of the
consumer.
• Price of the substitute product: A substitute product is one that
provides the same level of satisfaction as the product already
being consumed by the consumer. Assume that two products A
and B are perfect substitutes for each other. If the price of a
product goes up, while B remains constant, consumers will switch
to product B. For ex, with the technological advancement in the
telecommunication sector, wireless in local loop is being
considered as a substitute for cellular phone in the long run.
Similarly bio fertilizer proved to be good substitute for chemical
fertilizers.

12. • Price of complementary product: Complementary
products are products that are consumed together . For
ex, car and petrol or shoe and polish etc. In this case if
the price of one product goes up the demand for the
other product decreases.
• Changes in policy: The demand for a particular product
also depends upon government policies. For ex, if the
govt increases taxes on products, price increase and
hence the demand decreases in the short run.
Change in govt policies may also have a negative impact
on the demand for a particular product. The AP
government’s ban on Gutkha had a negative impact on
the demand for tobacco in Andhra Pradesh. Now the
tobacco industry in AP is facing over supply as a result of
lack of demand for tobacco products and hence the
companies operating in this industry have to search for
newer markets in other states.

13. • Tastes and preferences of the consumer: Tastes
and preferences of the consumer also affect the demand for a
product. To an extent, prevailing fashion, advertising and an
overall increase in standard of living influence consumer tastes.
When multinational fast food chains like Pizza Hut and Mc
Donald’s entered India, they found that their products did not
cater to the Indian tastes. The use of beef and pork is not widely
acceptable in India. These companies had to alter their menu
to make it more suitable to Indian consumers.
• Existing wealth of the consumer: While considering the
purchasing power of the consumer, current income is not the
only factor that brings about a shift in the demand curve. The
existing wealth of the consumer can be in the form of stocks,
bonds, real estate etc, which can be used to purchase goods.

14. • Expectations regarding future prices changes: If a
consumer expects a fall in the price of product in the near future he
may reduce his present consumption of that product. However, the
extent to which he can reduce his present consumption depends on the
nature of the product. If the product is essential or perishable one, the
consumer cannot postpone his purchase. For ex if reduction of petrol
prices is expected in near future consumers tend to postpone their
purchases. However, they can do it only for a certain period because
petrol being a commodity of regular use, its requirement cannot be
postponed for too long.
• Special influence: Demand is also influenced by factors like
climatic changes, demographic changes etc. Certain factors may affect
the demand only for a particular product. For ex the demand for
woolen garments goes up only a winter. In India the demand for cars is
influenced by various factors like per capita income, introduction of
new models, availability and cost of car financing schemes, prices of
other models of cars, prevailing duties and taxes, depreciation norms ,
fuel cost, public transport facilities.

15. Demand Schedule: A demand schedule is a tabular presentation of
the amount of goods consumers are willing and able to buy at
different level of prices over a given period of time.
Demand Curve: The graphical representation of demand schedule is
the demand curve. The demand curve is a downward sloping curve
from left to right. This characteristic of the demand curve is due to
the inverse relationship between price and quantity demanded.
A Demand Table 6.00
A Demand Curve
Price per DVD rentals 5.00
cassette Rs. demanded per Price per DVDs (in rupees)
week 4.00 E
3.50 G
A 0.50 9 D
3.00
B 1.00 8 Demand
2.00 C for DVDs
C 2.00 6
D 3.00 4 1.00 B
F A
E 4.00 2 .50
1 2 3 4 5 6 7 8 9 10
Quantity of DVDs demanded (per week) 15

16. Nature of Demand curve:
• A Demand Curve is a graphical representation of the
relationship between price and quantity demanded
(ceteris paribus). It is a curve or line, each point of
which is a price-Quantity. That point shows the
amount of the good buyers would choose to buy at
that price.
• The Law of Demand states that when the price of a
good rises, and everything else remains the same,
the quantity of the good demanded will fall.
• “Everything else remains the same is an
assumption. In this context, it means that income,
wealth, prices of other goods, population, and
preferences all remain fixed.

17. Variation & Changes in Demand Curve
• The law of demand explains the effect of only-one
factor viz., price, on the demand for a commodity,
under the assumption of constancy of other
determinants.
• In practice, other factors such as, income, population
etc. cause the rise or fall in demand without any
change in the price.
• These effects are different from the law of demand.
They are termed as changes in demand in contrast to
variations in demand which occur due to changes in
the price of a commodity.
• In economic theory a distinction is made between (a)
Variations i.e. extension and contraction in demand
due to price and (b) Changes i.e. increase and
decrease in demand due to other factors.

18. a) Variations in demand refer to those which occur due
to changes in the price of a commodity.
•These are two types.
•Extension of Demand: This refers to
rise in demand due to a fall in price of
the commodity. It is shown by a
downwards movement on a given
demand curve.
•Contraction of Demand: This means
fall in demand due to increase in price
and can be shown by an upwards
movement on a given demand curve.
•In figure A, the original price is OP
and the Quantity demanded is OQ.
With a rise in price from OP to OP1
the demand contracts from OQ to
OQ1 and as a result of fall in price
from OP to OP2, the demand extends
from OQ to OQ2.

19. (b) Changes in demand imply the rise and fall due to factors
other than price.
•It means they occur without any change in price.
They are of two types.
•Increase in Demand: This refers to higher
demand at the same price and results from rise in
income, population etc., this is shown on a new
demand curve lying above the original one.
•Decrease in demand: It means less quantity
demanded at the same price. This is the result of
factors like fall in income, population etc. this is
shown on a new demand lying below the original
one.
•In figure, B an increase in demand is shown by a
new demand curve, D1 while the decrease in
demand is expressed by the new demand curve
D2, lying above and below the original demand
curve D respectively. On D1 more is demand
(OQ1) at the same price while on D2 less is
demanded (OQ2) at the same price OP.

21. Increase in demand/Forward Shift.
• When more of a commodity is brought than
before at any given price there is an increase in
demand. It signifies either that more will be
demanded at a given price or same quantity will
be demanded at a higher price.
• An increase in demand really means that more is
now demanded than before at each and every
price. Hence, the demand curve shifts to right.

22. Reasons for increase in demand.
• Changes in fashions
• Increase in the income of the consumer
• A rise in the prices of substitutes
• A fall in the prices of complementary goods.
• If the people expect that price will rise in future.
• Increase in population
• Effect of increased advertisements.

23. Decrease in Demand/Backward shift.
• A decrease in demand signifies either less than
will be demanded at the same price or the same
quantity is demanded at a lower price.
• Decrease in demand really means that less is
now demanded than before at each and every
rise in price.
• In this case the demand curve will shift to the
left or backward shift.

24. Reasons for Decrease in demand/Backward shift.
• A good has gone out of fashion or the tastes of
people for a commodity have declined.
• Income of the consumer has fallen
• The prices of the substitutes of commodity have
fallen
• The prices of the complements of the commodity
have risen
• If the people expect that the price of a good will
fall in future which will affect their demand in the
present period.

25. Following are the exception to the law of demand
• 1. Giffen’s Paradox: A paradox is a foolish or absurd
statement, but it will be true. Sir Robert Giffen, an
Irish Economists, with the help of his own example
(inferior goods) disproved the law of demand.
• The Giffen’s paradox holds that “Demand is
strengthened with a rise in price or weakened with
a fall in price”.
• He gave the example of poor people of Ireland who
were using potatoes and meat as daily food articles.
When price of potatoes declined, customers instead
of buying greater quantities of potatoes started
buying more of meat (superior goods).
• Thus, the demand for potatoes declined in spite of
fall in its price.

26. • 2. Veblen’s effect : Thorstein Veblen, a noted American
Economist contends that there are certain commodities
which are purchased by rich people not for their direct
satisfaction, but for their ‘snob – appeal’ or‘ ostentation’.
• Veblen’s effect states that demand for status symbol
goods would go up with a arise in price and vice versa.
• In case of such status symbol commodities it is not the
price which is important but the prestige conferred by
that commodity on a person makes him to go for it.
• More commonly cited examples of such goods are
diamonds and precious stones, world famous paintings,
commodities used by world figures, personalities etc.
Therefore, commodities having ‘snob – appeal’ are to be
considered as exceptions to the law of demand.

27. • 3. Fear of shortage : When serious shortages are
anticipated by the people, (e.g., during the war
period) they purchase more goods at present
even though the current price is higher.
• 4. Speculation: When people speculate about
changes in the price of a commodity in future,
they may not act according to the law of
demand. In the stock exchanged market some
people tend to buy more shares which their
prices are raising, in the hope that the rising
trend would continue, so they can make a good
fortune in future.

28. • 5. Snobbish Feeling: Some times people buy
even at a higher price because of the irrational
feeling that by paying a higher price they will be
consuming a better commodity.
• 6. Ignorance: Customer’s ignorance is another
exception to the law of demand. Sometimes
consumers pay a higher price for a commodity
because they will be ignorance of market
condition.

29. Elasticity of Demand
• The degree to which demand for a good or service
varies with its price. Normally, sales increase with
drop in prices and decrease with rise in prices.
• As a general rule, appliances, cars, confectionary
and other non-essentials show elasticity of
demand whereas most necessities (food,
medicine, basic clothing) show inelasticity of
demand (do not sell significantly more or less with
changes in price).

30. • Elasticity is the proportional [or percent] change in one
variable due to the proportional change in another
variable. Therefore, elasticity is:
E = % change in x / % change in Y
• When the proportional change in one variable is equal
to proportional change in the other variable, it is called
unit elasticity E=1
• When E>1 , it is called relatively elastic.
• When E=0 , it is called perfectly inelastic.
• When E=∞, it is called perfectly elastic.
• When E<1 , it is called relatively inelastic.

31. Price Elasticity of Demand
• Price elasticity of demand measures the degree of correlation
between demand and price.
• Price elasticity of demand is defined as the percentage change in
quantity demanded of a product due to the percentage change in
its price, other thins remaining same.
Proportionate change in Quantity Demanded
Ep = _____________________________________
Proportionate change in Price.
• The price elasticity of demand measures the change in the
quantity demanded for a good in response to a change in price.
• Measures the responsiveness of quantity demanded to changes
in a good’s own price.

32. Different Degree of Price Elasticity of Demand
• 1.Perfectly Elastic Demand: No reduction in price
is needed to cause an increase in quantity
demanded, in perfectly elastic demand.
• Perfectly elasticity is infinite when a small rise in
price may result in the contraction of demand
even to zero and a small fall in price may result in
the extension of demand to unimaginable
condition.

33. • 2. Perfectly Inelastic Demand: When a change in
price causes no change in quantity demanded,
demand is said to be perfectly inelastic.
• Elasticity in such cases is zero and the demand is
insensitive or non-responsive to price changes.
• Hence a large fall in price
does not increase the
quantity demanded and
a large rise in price
does not decrease the
quantity demanded.

34. • 3. Relative Elastic Demand: It is a situation in
which a small change in price will lead to a big
change in the quantity demanded.
• Hence a small proportionate change in the price
of a commodity is accompanied by a large
proportionate change in its quantity demanded.

35. • 4. Relatively Inelastic Demand: It is a condition
in which a big proportionate change in price
results in a small change in the quantity
demanded.
• It refers to a condition where a change in price
causes a less than proportionate change in
quantity demanded.

36. • 5. Unitary elastic demand: It is situation in
which a change in price will result in an exactly
equal change in the quantity demanded.
• Elasticity of demand is unitary or one when a
given proportionate change in price causes an
equally proportionate change in quantity
demanded.

37. Significance of Price Elasticity of Demand
• Profit maximization requires that business set a
price that will maximize the firm’s profit
• Elasticity tells the firm how much control it has
over using price to raise profit
• If Ep > 1, then the % Change in Qd > % Change is
Price and demand is said to be Relatively elastic
• An increase in price will reduce total revenue
• A decrease in price will increase total revenue

38. • If Ep < 1, then the % change in Qd < % change in
price, and demand is said to be relatively inelastic
• An increase in price will increase total revenue
• A decrease in price will decrease total revenue
• If Ep = 1, then the % change in Qd = % change in
Price, and demand is said to be unit elastic
• An increase in price will have no impact on total
revenue
• A decrease in price will have no impact on total
revenue

39. Factors determining price elasticity of demand:
• Availability and closeness of substitutes: Those
products which have fewer close substitutes,
tend to have lower price elasticity than those
having more good substitutes. In other words
fewer the close substitutes, less elastic the
demand for the product. For ex, Demand for
utilities like water and electricity is relatively
inelastic because consumers have no choice.
Consumers have to buy the same even at higher
tariffs. On the other hand, if movie theaters raise
their ticket prices, consumers can see movies at
home on a VCD players or cable television or may
even switch to other forms of entertainment.

40. • Proportion of income spent on the product:
Demands tend to be inelastic for those
products and services that account for a small
proportion of consumer’s total expenditure. In
contrast even a small rise in the price of a
product that accounts for a large part of the
consumer’s expenditure make them evaluate
that expenditure. For ex, a major increase in
price of product like sugar will not have a
major impact on a consumer’s expenditure.

41. • Time period: Demand is more elastic in the
long run than in the short run. Longer the
time period considered , more would be the
chances of consumers substituting the
product under considerations with a cheaper
substitute. For ex, if the price of petrol keeps
on increasing with diesel prices remaining
unchanged , consumers would replace their
petrol cars with diesel cars in the long run.

42. • Uses of the product: The price elasticity of
demand would be higher for those products
which have large number of uses. Consumers
rank various uses of a product in the order of
their importance. When the price of the
product increases consumers may buy few units
of that product for its most important uses.
• Habit formation: Some products are consumed
more due to habit of consumers like cigarettes
and alcohol. The demand for such product is
relatively inelastic, since the consumers form a
habit of consuming them.

43. Income Elasticity of Demand
• Definition: Income elasticity of demand measures the
degree or the rate of change in quantity demanded of a
good when there is some change in the consumer’s
income. It measures the response of the quantity sold to a
change in consumer’s income.
• A measure of the extent to which the demand for a good
changes when income changes, ceteris paribus.
Ei= % Change in Quantity Demanded
% Change in Income
 If income elasticity of demand Ei > 1 the demand for the
good is income elastic, then the % Change in demand is more
than the % Change in income.
 If income elasticity of demand Ei is between 0 and 1, the
demand is income inelastic, then the % Change in demand is
less than % Change in income.
 If income elasticity of demand Ei< 0 the demand is negative
income elastic,

44. Income Demand for normal goods
D
Y3
Y2
Income
Y1
D
O M2 M3
M1
Quantity demanded

45. Income Demand for an Inferior goods
D
Y2
Y1
Income D
O M2 M1
Quantity demanded

46. Kinds of Income Elasticity
• Zero Income Elasticity of Demand: This refers
the situation where a given increase in the
income of the consumer does not result in any
increase in demand. The quantity brought of the
commodity remains constant.
• Negative Income Elasticity of Demand for
Inferior goods: This refers to that situation where
a given increase in the money income of the
consumer is followed by a actual fall in the
quantity demanded of commodity. For inferior
goods generally income elasticity will be
negative.

47. • Unitary Income Elasticity of Demand: In this
cause the proportion of the consumer’s income
spent on the commodity in question is exactly
the same both before and after the increase in
income. The income elasticity of demand here
is equal to unity.
• Income Elasticity of Demand Greater than
Unity: In this situation the consumer spends a
greater proportion of his money. Income on
the commodity in question, when he becomes
richer and more prosperous. The income
elasticity of demand is greater than unity in the
case of comforts and luxuries.

48. • Income Elasticity of Demand less than unity: In
this case, the consumer spends a smaller
proportion of his money income on the
commodity in question when his income
increases. The income elasticity of demand is
less than unity in the case of necessaries, the
expenditure on which increases in a smaller
proportion when the consumer’s money income
increases.

49. Practical significance of income elasticity of demand:
• For Demand Forecasting: In developing countries like
India, the incomes of the poor and middle class kept on
rising due to economic development. Income elasticity
helps producers and businessmen in forecasting
demand for non-essential goods like comforts and
luxuries,Ey for which is greater than one. These goods
are income elastic. Such forecasting enables the private
sector to undertake new projects or expand the
existing ones, such as production of CTVs, VCRs, cars,
superior quality cloth, house construction etc.
• Forward planning of expansion or new ventures can be
done by anticipating changes in the income levels of
the consumers.

50. • For taxing income: Luxuries are income elastic.
The rich spend lavishly on superfluous or non
essential goods. As the income levels increase, the
govt collects more from the rich by way of high
income tax and higher taxes on luxuries.
• Selection of markets: There are markets
patronized by the rich and markets with poor or
middleclass consumers. Suppliers and producers
supply accordingly different types of goods to
such markets; comforts and luxuries to the former
type of markets and essential to the latter. Market
strategies are thus decided on the basis of income
elasticity of demand. Luxuries and comforts are
sold in the markets having high income elasticity
of demand and essentials in markets with less
income elasticity.

51. Advertising Elasticity of Demand [AED]
• Advertising elasticity of demand measures the extent of change in
the quantity demanded of a product to change in expenditure on
advertising and other promotional activities.
• AED measures the percentage change in the quantity of a good
demanded induced by a given percentage change in spending on
advertising in that sector.
• Purpose
– To make the demand for a product greater
– To make the demand for a product more inelastic
• Good advertising will result in a positive shift in demand for a good.
AED is used to measure the effectiveness of this strategy in
increasing demand versus its cost.
• AED is usually positive. Negative advertising may, however, result in
a negative AED.

52. Determinants of Advertising elasticity of demand:
Advertising elasticity of demand differs between
products. Even the same product may not
respond in the same manner to different levels of
advertising expenditure. Some of the important
factors affecting advertising elasticity of demand
are
 Effect of time: Response to advertisements varies
depending upon the type of the product. For ex,
durable products take longer time because the
consumers will buy new products only when the
existing ones becomes unusable or obsolete. The
difference in time lag of response for various
products varies the advertising elasticity of
demand for different products.

53. Stages of product: The advertising elasticity of
demand varies for new as well as old
products. It also differs for products with an
established and a growing market.
Advertising by competitors: Advertising
elasticity of demand also depends upon how a
firm’s competitors react to its advertising
campaigns. The extent of impact on the
advertising and its revenues of a firm will
depend on the past and present
advertisement campaigns carried by that
firm’s competitors.