COURSE: GENERAL ECONOMICS

ACADEMIC YEAR: 2024/2025

Level: License 1

Module 4: Theory of Demand

Introduction
Theory of demand
Demand schedule, demand curve and demand function
Determinants of demand
Elasticity of demand
Price Elasticity of Demand
Income Elasticity of Demand
Cross price Elasticity of Demand

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 THEORY OF DEMAND

Introduction
The theory of demand is a fundamental concept in economics that explains how
consumers decide to purchase goods and services. It focuses on the relationship
between the price of a good and the quantity demanded by consumers, as well as
the factors that influence this relationship.

Definition of Demand
In our day-to-day life we use the word ‘demand’ in a loose sense to mean a desire
of a person to purchase a commodity or service. But in economics it has a specific
meaning, which is different from what we use it in our day-to-day activities.
Demand refers to the quantity of a good or service that consumers are willing
and able to buy at different prices over a specific period of time, assuming
other factors remain constant (ceteris paribus).
It states that the consumer must be willing and able to purchase the commodity,
which he/she desires. His/her desire should be backed by his/her purchasing power.
A poor person is willing to buy a car; it has no significance, since he/she has no
ability to pay for it. On the other hand, if his/her desire to buy the car is backed by
the purchasing power then this constitutes demand.
Demand, thus, means the desire of the consumer for a commodity backed by
purchasing power. These two factors are essential. If a consumer is willing to buy
but is not able to pay, his/her desire will not become demand. Similarly, if the
consumer has the ability to pay but is not willing to pay, his/her desire will not be
called demand.
More specifically, demand refers to various quantities of a commodity or service
that a consumer would purchase at a given time in a market at various prices, given
other things unchanged (ceteris paribus). The quantity demanded of a particular
commodity depends on the price of that commodity.

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 Law of Demand
The law of demand states that:
• When the price of a good decreases, the quantity demanded increases.
• When the price of a good increases, the quantity demanded decreases.
This relationship is inverse and is represented graphically by a downward-sloping
demand curve.

Importance of Demand in Economics

Understanding demand is crucial for:
• Businesses: To set prices, forecast sales, and plan production.
• Governments: To design policies affecting consumption, taxation, and
subsidies.
• Consumers: To make informed purchasing decisions based on price
changes and income.

Demand schedule (table), demand curve and demand function

The relationship that exists between price and the amount of a commodity purchased
can be represented by a table (schedule) or a curve or an equation.
Demand schedule (DS)
DS can be constructed for any commodity if the list of prices and quantities
purchased at those prices are known. An individual demand schedule is a list of the
various quantities of a commodity, which an individual consumer purchases at
various levels of prices in the market. A demand schedule states the relationship
between price and quantity demanded in a table form.

Table 2.1 Individual household demand for orange per week

Combinations A B C D E
Price per kg 5 4 3 2 1
Quantity demand/week 5 7 9 11 13

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 Demand Curve (DC)
• Graph Representation: The demand curve shows the relationship between
price (vertical axis) and quantity demanded (horizontal axis).
• Movement Along the Curve: Changes in price cause movements along the
demand curve (e.g., from one point to another).
Thus, DC is a graphical representation of the relationship between different
quantities of a commodity demanded by an individual at different prices per time
period.

In the above diagram prices of oranges are given on ‘OY’ axis and quantity
demanded on ‘OX’ axis. For example, when the price per kilogram is 1 the quantity
demanded is 13 kilograms. From the above figure you may notice that as the price
declines quantity demanded increases and vice-versa.

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 Demand Function
The demand function is a mathematical representation of the relationship between
the quantity of a good demanded and its various influencing factors. It provides an
equation that helps economists and businesses predict how changes in these factors
affect consumer behavior.
Definition of the Demand Function
The demand function expresses how the quantity demanded (Qd) of a good or
service depends on its price and other determinants. It is typically written as:
Qd=f(P,I,Ps,Pc,T,E,N) Qd = f(P, I, Ps, Pc, T, E, N)
Where:
• PP: Price of the good

• II: Income of consumers

• Ps: Price of substitutes
• Pc: Price of complements
• TT: Tastes and preferences
• EE: Expectations of future prices
• NN: Number of buyers

Simplified Demand Function

In its simplest form, the demand function focuses on the price of the good:
Qd= a−bP
Where:
• a: The quantity demanded when the price is zero (intercept of the demand
curve).
• b: The slope of the demand curve, showing the rate at which quantity
demanded changes as price changes.
This equation represents the law of demand, where an increase in price (P) leads
to a decrease in quantity demanded (Qd).

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 Market Demand
The market demand schedule, curve or function is derived by horizontally adding
the quantity demanded for the product by all buyers at each price.
Table 2.2: Individual and market demand for a commodity
Price Individual demand Market
Consumer-1 Consumer-2 Consumer-3 Demand
8 0 0 0 0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20

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 Numerical Example
Suppose the individual demand function of a product is given by:
P=10 - Q /2 and there are about 100 identical buyers in the market. Then the
market demand function is given by:

P= 10 - Q /2 ↔ Q /2 =10 - P ↔ Q= 20 - 2P and

Qm = (20 – 2P) 100 = 2000-200P

Determinants of demand
Factors other than price that affect demand are called determinants of demand,
and they shift the demand curve. These include:
Income: As consumer income rises, demand for normal goods typically increases,
while demand for inferior goods decreases.
Tastes and Preferences: Changes in consumer preferences can increase or
decrease demand.
Prices of Related Goods:
o Substitutes: If the price of a substitute good rises, demand for the
original good increases.
o Complements: If the price of a complementary good rises, demand
for the original good decreases.
Consumer Expectations: Expectations of future price changes or availability can
influence current demand.
Number of Buyers: More buyers in the market increase demand.

When we state the law of demand, we kept all the factors to remain constant except
the price of the good. A change in any of the above listed factors except the price of
the good will change the demand, while a change in the price, other factors remain
constant will bring change in quantity demanded. A change in demand will shift the
demand curve from its original location. For this reason, those factors listed above
other than price are called demand shifters. A change in own price is only a
movement along the same demand curve.

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 Changes in demand
A change in any determinant of demand—except for the good’s price causes the
demand curve to shift. We call this a change in demand. If buyers choose to purchase
more at any price, the demand curve shifts rightward—an increase in demand. If
buyers choose to purchase less at any price, the demand curve shifts leftward—a
decrease in demand.

Key Determinants of Demand with Examples

1. Price of the Good (P)
o Explanation: The most direct determinant of demand is the price of
the good or service itself.
o Impact:
▪ When the price of a good decreases, the quantity demanded
increases (law of demand).
▪ When the price increases, the quantity demanded decreases.
o Example:
▪ If the price of coffee drops from $5 to $3 per cup, more people
will buy coffee.

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 2. Income of Consumers (I)
o Explanation: The amount of money consumers have affects their
ability to purchase goods.
o Impact:
▪ Normal Goods: Demand increases as income rises (e.g.,
organic food, electronics).
▪ Inferior Goods: Demand decreases as income rises (e.g.,
instant noodles, second-hand clothing).
In general, inferior goods are poor quality goods with relatively lower price and
buyers of such goods are expected to shift to better quality goods as their income
increases.
However, the classification of goods into normal and inferior is subjective and it is
usually dependent on the socio-economic development of the nation.
Example: A person earning $1,000 per month might buy instant noodles, but if
their income rises to $3,000 per month, they may switch to dining at restaurants.

3. Prices of Related Goods

Two goods are said to be related if a change in the price of one good affect the
demand for another good. Demand is influenced by the prices of substitute and
complementary goods.
There are two types of related goods. These are substitute and complimentary goods.
Substitute goods are goods which satisfy the same desire of the consumer.
For example, tea and coffee or Pepsi and Coca-Cola are substitute goods. If two
goods are substitutes, then price of one and the demand for the other are directly
related.

Complimentary goods, on the other hand, are those goods which are jointly
consumed.
For example, car and fuel or tea and sugar are considered as compliments. If two
goods are complements, then price of one and the demand for the other are inversely
related.

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 4. Tastes and Preferences (T)
o Explanation: Changes in consumer preferences due to trends,
advertising, or cultural shifts affect demand.
o Impact: Positive changes in preferences increase demand, while
negative changes reduce it.
o Example:
▪ If a celebrity promotes a particular brand of sneakers, demand
for that brand increases.
▪ Conversely, if a health report warns against consuming sugary
drinks, demand for sodas might decline.

5. Expectations of Future Prices (E)

Explanation: Consumers' expectations about future prices or income levels can
influence current demand.
Impact:
If consumers expect prices to rise, they may purchase more now (increased current
demand).
If they expect prices to fall, they may delay purchases (decreased current demand).
Example: If people expect the price of laptops to drop during a holiday sale, they
might postpone buying until then.

6. Number of Buyers (N)

Explanation: The size of the market or the population directly affects demand.
Since market demand is the horizontal sum of individual demand, an increase in
the number of buyers will increase demand while a decrease in the number of
buyers will decrease demand.
Impact:
More buyers in the market increase total demand.
Fewer buyers reduce total demand.
Example: A growing city population increases the demand for housing and
transportation services.

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 7. Consumer Demographics
o Explanation: Age, gender, occupation, and lifestyle of consumers
also influence demand.
o Example:
▪ Young people may demand more gaming consoles, while older
adults might demand more health-related products.

Practical Scenario Combining Determinants

Imagine the demand for electric cars:
• Price: If the price of electric cars falls, demand increases.
• Income: Rising incomes enable more people to afford electric cars.
• Substitutes: Higher gasoline prices (a substitute fuel) increase demand for
electric cars.
• Complements: Falling prices of charging stations (a complementary good)
also boost demand.
• Preferences: Growing environmental awareness makes electric cars more
attractive.
• Expectations: Anticipation of government subsidies might lead people to
delay purchases until subsidies are announced.
• Population: As urban areas grow, demand for eco-friendly transportation
options rises.

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 Elasticity of demand
In economics, the concept of elasticity is very crucial and is used to analyze the
quantitative relationship between price and quantity purchased or sold.
Elasticity of demand is a measure of how responsive the quantity demanded of a
good or service is to changes in factors such as price, income, or the price of
related goods. It is a key concept in economics because it helps us understand
consumer behavior and market dynamics.
Commonly, there are three kinds of demand elasticity: price elasticity, income
elasticity, and cross elasticity.

Price Elasticity of Demand

Price elasticity of demand means degree of responsiveness of demand to change in
price. It indicates how consumers react to changes in price. The greater the reaction
the greater will be the elasticity, and the lesser the reaction, the smaller will be the
elasticity.

Price elasticity of demand is a measure of how much the quantity demanded of a

good respond to a change in the price of that good, computed as the percentage
change in quantity demanded divided by the percentage change in price.

Examples:
Elastic: Luxury items like designer handbags. A 10% price increase may reduce
demand by 20%.
Inelastic: Necessities like salt or gasoline. A 10% price increase may reduce
demand by only 2%.
Demand for commodities like clothes, fruit etc. changes when there is even a small
change in their price, whereas demand for commodities which are basic necessities
of life, like salt, food grains etc., may not change even if price changes, or it may
change, but not in proportion to the change in price.

Price elasticity demand can be measured in two ways, which are point and arc
elasticity.

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 a. Point Price Elasticity of Demand
This is calculated to find elasticity at a given point. The price elasticity of demand
can be determined by the following formula.

In this method, we take a straight-line demand curve joining the two axes, and
measure the elasticity between two points Qo and Q1 which are assumed to be
intimately close to each other.

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On a straight-line demand curve, we can make use of this formula to find out the
price elasticity at any particular point. We can find out numerical elasticities also
on different points of the demand curve with the help of the above formula. It
should be remembered that the point elasticity of demand on a straight line is
different at every point.

b. Arc price elasticity of demand

The main drawback of the point elasticity method is that it is applicable only when
we have information about even the slight changes in the price and the quantity
demanded of the commodity.
But in practice, we do not acquire such information about minute changes. We may
possess demand schedules in which there are big gaps in price as well as the quantity
demanded. In such cases, there is an alternative method known as arc method of
elasticity measurement.

In arc price elasticity of demand, the midpoints of the old and the new values of both
price and quantity demanded are used. It measures a portion or a segment of the
demand curve between the two points. An arc is a portion of a curve line, hence, a
portion or segment of a demand curve.

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Example: Suppose that the price of a commodity is 5 and the quantity demanded
at that price is 100 units of a commodity. Now assume that the price of the
commodity falls to 4 and the quantity demanded rises to 110 units. In terms of the
above formula, the value of the arc elasticity will be.

Interpretation:
▪ Elastic Demand (PED>1PED > 1): A small price change leads
to a large change in quantity demanded.
▪ Inelastic Demand (PED<1PED < 1): A large price change
leads to a small change in quantity demanded.
▪ Unitary Elastic Demand (PED=1PED = 1): Proportional
change in price and quantity demanded

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 Determinants of price Elasticity of Demand
The following factors make price elasticity of demand elastic or inelastic other than
changes in the price of the product.
a) The availability of substitutes: the more substitutes available for a product, the
more elastic will be the price elasticity of demand.
b) Time: In the long- run, price elasticity of demand tends to be elastic. Because:
• More substitute goods could be produced.
• People tend to adjust their consumption pattern.
c) The proportion of income consumers spend for a product:
-the smaller the proportion of income spent for a good, the less price elastic will
be.
d) The importance of the commodity in the consumers’ budget:
• Luxury goods → tend to be more elastic, example: gold.
• Necessity goods → tend to be less elastic example: Salt.

Price Elasticity of Demand (PED)

Exercise: Calculating PED
The price of a coffee cup increases from $4 to $5, causing the quantity demanded
to drop from 200 cups to 150 cups per day.
1. Calculate the price elasticity of demand.
2. Interpret the result.

Correction:

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 Income Elasticity of Demand (YED)

Exercise : Calculating YED

When consumer income rises from $2,000 to $2,500 per month, the demand for
luxury watches increases from 100 to 150 units.
1. Calculate the income elasticity of demand.
2. Classify the good based on the result.

Correction:

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 Cross price Elasticity of Demand

Example: Consider the following data which shows the changes in quantity
demanded of good X in response to changes in the price of good Y.
Unit price of Y Quantity demanded of X
10 1500
15 1000

Cross-Price Elasticity of Demand (XED)

Exercise: Calculating XED
The price of tea increases from $3 to $4 per box, causing the demand for coffee to
rise from 80 to 120 cups per day.
1. Calculate the cross-price elasticity of demand.
2. Determine the relationship between tea and coffee based on the result.

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Correction:

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