DEMAND ANALYSIS

Objectives/ Learning Outcomes

By the end of this topic you will be able to:

1. Explain the meaning of Demand, types and determinants of demand

2. Describe the Demand Function, law of demand, demand schedule and demand curve
3. Explain the shifts of Demand Curve v/s Movement along the demand curve and the
effect of a price change
4. Describe the different elasticities of Demand: price elasticity, point elasticity
5. Explain the relationship between marginal revenue and price elasticity, determinants
of Price Elasticity of Demand and the relationship between Price elasticity and
Decision Making
6. Explain the exceptions to the Law of Demand – Upward Sloping Demand Curve
7. Explain the Theory of Consumer Behavior, cardinal utility theory, equilibrium of the
consumer, the ordinal utility theory in which there is the equilibrium of the consumer
and properties of indifference curves
8. Explain the consumer surplus

Meaning of Demand

Conceptually, demand can be defined as the desire for a good backed by the ability and
willingness to pay for it. The desire without adequate purchasing power and willingness to
pay does not constitute or become effective demand. Only an effective demand matters in
economic analysis and business decisions.

Types of Demand

The demand for various commodities is generally classified on the basis of the consumers of
the product, suppliers of the product, nature of goods, duration of the consumption of the
commodity, interdependence of demand, period of demand and nature of use of the
commodity (intermediate or final).

 Individual and Market Demand

 Autonomous and derived demand

 Demand for durable and non-durable goods

 Demand for firm’s products and industry products

  Demand for consumers and producer goods

Individual and Market Demand

Individual’s demand for a commodity is the quantity of a commodity which an individual is

willing to buy at a particular price during a specific time period given his money income, his
taste and prices of other commodities. On the other hand, market demand for a commodity is
the summation of individual demand by all the consumers. Market demand is a multivariate
relationship that is determined by many factors simultaneously. Some of the most important
determinants of the market demand for a particular commodity are its own price, consumer’s
income, prices of other commodities, consumer’s tastes and preferences, income distribution,
total population, consumer’s wealth, credit availability, Government policy, past level of
income and past level of demand.

Autonomous and derived demand

The demand for a commodity that arises out of a natural desire to consume or possess a
commodity independent of the demand of other commodities, such as substitute goods or
complementary ones is called independent demand. Commodities like tea and vegetables do
come on absolute terms. On the other hand, if the demand for a product is tied to the demand
for some parent product, such demand is called derived demand.

Demand for durable and nondurable goods

Durable goods are those whose total utility is not exhausted in a single or short run use. Such
goods can be used repeatedly over a period of time. Durable goods may be consumer goods
as well as producer goods. The demand for durable goods changes over a relatively longer
period. Perishable (non-durable) goods are defined as those which can be used only once.
Their demand is of two types i.e. those that replace old products and expansion of existing
stock. The demand for non-durable goods depends largely on their prices, consumer income
and is subject to frequent change.

Demand for firm’s products and industry products

Firm’s demand means the demand for the products or services by a particular company or
firm whereas industry demand is the aggregation of demand for the products or services of all
the firms in an industry as a whole. A clear understanding of the relationship between
company and industry demand necessitates the understanding of different market structures.
These structures can be differentiated on the basis of product differentiation and number of
sellers.

Demand for consumer and producer goods

Consumer goods are those, which are, meant for the final consumption by the consumers or
end users. Producer goods on the other hand are used for the production of consumer goods
or they are intermediate goods, which are further processed into a form that can be used by
the end user. Another distinction is that the demand for producer goods is derived demand and
indirectly depends on the demand for the consumer goods. It may also be possible that this
demand may be augmented or emphasized in the same proportion as the change in the demand
for the final consumer goods. A small change in the demand for consumer goods may either
completely wipe out the demand for the producer goods or may accelerate it.

Determinants of Demand

 Commodity’s Own Price

 Prices of related goods → Substitutes and Complements

 Income level of consumer

 Tastes & Preferences

 Expectations

 Population

 Other exogenous factors

Demand Function

The determinants of quantity demanded when summarized in the form of functional notations
are called a demand function. A typical demand function can be specified as follows:

Dn = f( pn, p1, p2,…….pn-1, Y,T, Ep, Ey, Ad. Exp., N, D, u)

Where pn = price of n product

P1………Pn-1 = Prices of other products

Y = income level of consumers

T = Taste and preferences of consumers

Ep = expected prices

Ey = expected income

Ad. Exp. = advertising expenditure

N = number of consumers

D = distribution of consumers

u = other factors

Law of Demand

There is relationship between price of a product and quantity demanded of that product, ceteris
paribus i.e., other factors remaining constant.

Demand Schedule

A demand schedule is one way of showing the relationship between quantity demanded and
price, all other things being held constant.

Price($ per dozen) Quantity demanded

(dozen per month)

0.50 7.0

1.00 5.0

1.50 3.5

2.00 2.5

2.50 1.5

3.00 1.0

Demand Curve

Demand curve is the graphical representation of the relationship between price and quantity
demanded of a good, all other factors held constant. A demand curve is said to be linear when
its slope is constant all along the curve, whereas for a nonlinear or curvilinear curve the slope
never remains constant.
 P P

Q Q
Linear Demand Non – Linear Demand
Curve Curve
Shift of Demand Curve Vs Movement along the demand curve

A movement along the demand curve is in response to a change in price and leads to expansion
or Contraction of Demand, called Change in Quantity Demanded. On the other hand Shift in
the demand curve either upward or downward is in response to a change in one of the other
determinants of demand.

Effect of a Price Change

 Price Effect

 Income Effect – A price change causes Real Income to change and therefore
consumption of both goods changes
  Substitution Effect – Price change of one good causes the relative price of the two
goods to change and consumers substitute the relatively cheaper good for the more
expensive one.

Elasticities of Demand

There are as many elasticities of demand as its determinants. The most important of these
elasticities are:

 Price elasticity of demand

 Income elasticity of demand

 Cross elasticity of demand

The Price Elasticity of Demand

The price elasticity measures the responsiveness of demand to changes in the commodity’s
price. For very small changes in price, point elasticity of demand is used as a measure of
responsiveness of demand while arc elasticity of demand is the suitable measure for
comparatively large changes in price.

The point elasticity of demand is defined as the proportionate change in the quantity demanded
resulting from a very small proportionate change in price. Symbolically it is written as;

dQ
ffffffffff dP
fffffffff
ep  D
Q P

Or

dQ
ffffffffff Pfffff
ep  A
dP Q

If the demand curve is linear

Q  bo @b1 p

Its slope is dQ/ dP  @b1 Asubstituting in the elasticity formula we obtain

Pfffff
e p  @b1 A
Q
Which implies that the elasticity changes at the various points of the linear demand curve?

The range of values of the elasticity is

0  ep  1

If e p  0, the demand is perfectly inelastic.

If ep 1 , the demand is perfectly elastic

If e p  1, the demand is unitary elastic, total expenditure remain constant with a change in
price.

If 0 < e p < 1, the demand is inelastic total expenditure total expenditure and price change move
in the same direction.

If 1< e p < 1 the demand is elastic, total expenditure and price change move in the opposite
direction.
 0 < e p < 1, 1< e p < 1

The relationship between marginal revenue and price elasticity

The marginal revenue is related to the price elasticity with the formula
f g
1fff
MR  p 1 @
e

This is a crucial relationship for the theory of pricing

Proof

The total revenue is

 D b cE
TR  PQ  f Q Q

The MR is

pQ
fffffffffff dQ
ffffffffff dP
ffffffffff dP
ffffffffff
MR  d P Q P  Q
dQ dQ dQ dQ

The price elasticity of demand is defined as

ffffffffff 
dQ fffffff
ep  @
dP Q

Rearranging we obtain

P dP
fffffffff ffffffffff
@ 
eQ dQ

Substituting dP/ dQ in the expression of the MR we have

dP
ffffffffff P
fffffffff Pfffff
MR  P  Q  P @Q P@
dQ eQ e
f g
1fff
MR  p 1 @
e

We may summarize this relationship as follows:

 If the demand is inelastic (e < 1) an increase in price leads to an increase in total

revenue and vice versa.

 If the demand is elastic (e>1) an increase in price will lead to a decrease in total
revenue and vice versa.

 If the demand has unitary elasticity (e =1), total revenue is not affected by changes
in price.

Determinants of Price Elasticity of Demand

 Number and availability of Substitutes

 The proportion of income spent on the particular commodity

 Nature of the need that the product satisfies

  Length of time period under consideration

 The number of uses to which a commodity can be put

Price elasticity and Decision Making

 Information about price elasticities can be extremely useful to managers as they

contemplate pricing decisions.

 If demand is inelastic at the current price, a price decrease will result in a decrease in
total revenue.

 Alternatively, reducing the price of a product with elastic demand would cause
revenue to increase.

Remember TR = P*Q

The income elasticity of demand

The income elasticity of demand is defined as the proportionate change in the quantity
demanded resulting from a proportionate change in income. The income elasticity is positive
for normal goods. Symbolically it may be written as:

dQ fffffffff dQ
ffffffffff dY ffffffffff Yfffff
ey  D  A
Q Y dY Q

The cross elasticity of demand

The cross elasticity of demand is defined as the proportionate change in the quantity demanded
of x commodity resulting from a proportionate change in the price of y commodity. The sign
of cross elasticity is negative if x and y are complementary goods and positive if x and y are
substitutes. The higher the value of the cross elasticity the stronger will be the degree of
substitutability or complementarity of x and y. symbolically we may write it as:

dQ
ffffffffffff dP
ffffffffffff dQ
ffffffffffff Pffffffff
exy   xA
x y y
D
Qx P y dP y Qx
Classification of Goods
 Normal Goods – Demand Increases as Income increases
 Inferior Goods – Demand decreases as consumer Income increases
 Basic Necessities – Commodities like salt, food grains etc for which demand is
relatively inelastic and does not vary with income after a point

Exceptions to the Law of Demand – Upward Sloping Demand Curve

 Giffen Goods – a subclass of Inferior goods for which the income effect outweighs the
substitution effect

 Veblen Products / Snob effect – Goods that have a snob value attached to them for
which demand actually increases as price goes up

 Speculative Effect – In periods of rising prices, anticipation of future increases may

cause consumers to demand more

 Bandwagon Effect – Occurs when people demand a commodity only because others
are demanding it and in order to be fashionable

 Emergencies like war, famine etc.

Theory of Consumer Behavior

The consumer is assumed to be rational. Given his income and the market prices of the various
commodities, he plans the spending of his income so as to attain the highest possible
satisfaction or utility. This is the axiom of utility maximization. In order to attain this
objective, the consumer must be able to compare the utility of the various ‘baskets of goods’
which he can buy with his income. There are two basic approaches to compare the utilities,
the cardinalist approach and the ordinalist approach.

The Cardinal Utility Theory

The cardinal school stated that utility can be measured. Under certainty i.e., complete
knowledge of market conditions and income levels over the planning period utility can be
measured in monetary units, called utils. There are certain assumptions of cardinal utility
theory.

 Rationality of consumer

 Constant marginal utility of money

 Diminishing marginal utility

 Total utility is additive

Equilibrium of Consumer

Assuming the simple model of a single commodity x, the consumer can either buy x or retain
his money income y. Under these conditions the consumer is in equilibrium when the marginal
utility of x is equated to its market price.

MU x  Px

If there are more commodities, the condition for the equilibrium is the equality of the ratios
of the marginal utilities of the individual commodities to their prices.

MU
ffffffffffffffff MU
ffffffffffffffff MU
ffffffffffffffff
  
x y n
Px Py Pn

The Ordinal Utility Theory

The ordinalist school postulated the utility is not measurable, but is an ordinal magnitude. It
suffices for the consumer to be able to rank the various baskets of goods according to the
satisfaction derived. The main ordinal theory is known as the indifference-curve theory is
based on certain assumptions.

 Rationality of consumer

 Utility is ordinal

 Diminishing Marginal rate of substitution

 Consistency and transitivity of choice

 Total utility depends on the quantities of the commodities consumed

Equilibrium of Consumer

The consumer is in equilibrium when he maximizes his utility, given his income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.

The first condition is that the marginal rate of substitution be equal to the ratio of commodity
prices. This is necessary but not sufficient condition.

MU
ffffffffffffffff Pffffffff
MRS x ,y  x
 x
MU y P y

The second condition is that the indifference curve be convex to the origin. This condition is
fulfilled by the axiom of diminishing marginal rate of substitution of x for y and vice versa.

At the point of
tangency (point e) the
slopes of the budget
line ( P x / P y ) and of the
indifference curve (
MRS x ,y  MU x / MU y )

are equal:

MU
ffffffffffffffff Pffffffff
MRS x ,y  x
 x
MU y P y

Properties of Indifference Curve

 An indifference curve has a negative slope

 The further away from the origin an indifference curve lies, the higher the utility it
denotes

 Indifference curve do not intersect

  The indifference curves are convex to the origin

The consumer surplus

Consumer surplus is equal to the difference between the amount of money that a consumer
actually pays to buy a certain quantity of a commodity and the amount that he would be willing
to pay for this quantity rather than do without it. Graphically the consumers’ surplus may be
found by his demand curve for commodity and the current market price, which he cannot
affect by his purchase of that commodity.

Consumer surplus = PCA

Additional Resources:
https://opentextbc.ca/principlesofeconomics/chapter/5-1-price-elasticity-of-demand-and-price-
elasticity-of-supply/

https://www.economicscafe.com.sg/economics-lecture-notes-chapter-3/

https://www.khanacademy.org/economics-finance-domain/ap-microeconomics/unit-2-supply-
and-demnd/25/v/income-elasticity-of-demand

https://xplaind.com/206686/cross-elasticity-of-demand