Demand Analysis

Introduction:
Demand is one of the most critical economic decision variables. It
reflects the size and pattern of market. Business activity is always market-
driven. The manufacturers’ inducement to invest in a given line of
production depends on the size of market. In the process of production,
inputs are transformed into flows of output. Output, when sold in the market,
yields revenue. Inputs, to be obtained for the productive process, involve
costs. Profit is the difference between revenues and cost and it is influenced
by the demand-supply conditions for output and input. The demand for
output and inputs, the demand for firm and the industry, the demand by the
consumer and the stockiest, and the similar becomes therefore relevant for
managerial decision making.

Concept of Demand
The demand for anything, at a given price, is the amount of it, which a
person desires to buy per unit of time at a given place. Demand, thus, has
three important elements. First, it is a desired quantity and the phrase
quantity demanded is used for it. Second, demand must be backed with
enough money. So demand in economics is effective demand. Thirdly,
quantity demanded is a flow and not a stock.
The demand for a product implies (i) desire to acquire it, (ii)
willingness to pay for it and, (iii) ability to pay for it. All the three must be
checked to identify and establish demand. A beggar’s desire to stay in a five-
star hotel and his willingness to pay the bill is not demand because he lacks
necessary money to pay the bill of the hotel. It is merely his wishful
thinking. Similarly, a miser’s desire for and ability to pay for a car is not
demand, as he does not have necessary willingness to par for a car. One may
come across a well-established person who possesses both the willingness
and ability to pay for higher education. But he has really no desire to have it;
he pays the fee for a regular course, and eventually does not attend his
classes. Thus, in economic sense, he does not have a demand for higher
education (degree/diploma)
To sum up, the demand for a product is the desire for that product
backed by willingness as well as ability to pay for it. It is always defined
with reference to a particular time, place, price, and given values of other
variables on which it depends.
Determinants of Demand

 Price of the product

 Price of other related goods
 Consumer income and wealth
 Distribution of income and wealth
 Size of population
 Taste, preferences and fashion
 Demonstration effect
 Advertisement expenditure
 Price expectation of the consumer
 Availability of credit facility to consumer

Thus demand of a commodity, say X, may be the function of the following

variables:

Dx = f (Px, Py, Pz, Y, W, De, Di, A, E, T, P, C, )

Where:
Px = price of x commodity, Py = price of Y commodity (a substitutive
commodity),
Pz, = price of z commodity (a complementary commodity), Y = Income of
the consumer,
W = wealth of the consumer, De = demonstration effect, Di = distribution
o0f income and wealth in the society, A = advertisement expenditure, E =
price expectation of the consumer, T = taste, preferences and fashion, P =
size of population, C = credit facility available to consumer, and  =
disturbance term or error term

Demand Function
Demand, as a function of the above variables, becomes a very
complicated relationship. It would be difficult to formulate any demand
theory. Therefore, we presume that all variables, except the price of a
commodity, which we are considering, remain constant. Now we can state
the relationship between the quantity demanded of a commodity and its
price.

Dx = f (Px)
In the slope and intercept form, the demand function may be stated as;

Dx = a - b Px

Law of Demand
The law of demand states: if other things remain the same, price of a
commodity and its demand have inverse relationship. If the price increases,
its demand decreases and vice versa.
When the demand-price relation is shown in the form of a table, it is
called demand schedule and when it is plotted on a graph, it is called
demand curve. The demand curve is downward slopping indicating the
inverse relationship between the price of the product and its demand.

A demand schedule for Sugar

Price per Quantity

kg (Rs.) demande
d (kg)
2 10
3 8
4 6
5 4
6 2

In the above table, a hypothetical demand schedule, showing the range

of prices and the corresponding different quantities of the commodity a
buyer will buy, is given. The table shows inverse relationship between the
price and quantity demanded.

Why does demand curve slope downward?

A demand curve normally slopes downward from northwest to
southwest. There are various reasons for it. First, when the price is reduced,
new buyers of the commodity enter the market. Second, when the price falls,
the old consumers buy more of it because of income and substitution effects.
Third, the principle of different uses is also responsible for the downward
slope of demand curve. When the commodity is costly, it is used only in
more important uses but when the price falls, the commodity is also
demanded for less important uses. Lastly, the law of demand operates
because of the principles of different desires. People in a society are of
different taste, habits, liking etc. Some have stronger desires and others may
have weak desire. When the price is higher only those consumers who are of
strong desires buy that commodity. When the price falls, people with less
strong desires also start buying the commodity.

Change in Demand and Change in Quantity Demanded

It is important to draw simple distinction between change in demand
and change in quantity demanded. The law of demand has reference to
extension or contraction of demand (change in quantity demanded) but the
change in demand (increase or decrease in demand) is associated with the
change in other variable that affect the demand. When there is a movement
on the same demand curve due to change in the price of the product, the
quantity demanded of the product changes, which is called change in
quantity demanded. The movement of consumer from one demand curve to
another due to change in all other variables, except the price of the product,
is known as change in demand.

Exception of Law of Demand

1. Giffen Paradox
The law of demand is not applicable to Giffen goods i.e., inferior goods.
All Giffen goods are inferior goods but all inferior goods are not Giffen
goods. In case of giffen goods, when price of such good, say X, falls, the
negative income effect is so powerful to out-weight the positive
substitution effect. When the price falls, a consumer demands less.
Therefore, the law of demand does not hold true in case of these goods.
2. Conspicuous consumption
There are some goods, which are demanded by rich people only when
they are expensive. Rare paintings, diamond jewellery etc., fall in this
category. The consumption of these goods is known as conspicuous
consumption.
3. Fear of future rise in prices
If it is believed that the price of a commodity is likely to be higher in the
future than at present, then even though the price has already risen, more
quantity of the commodity may be bought at the higher price by the
consumer.

Types of Demand
1. Direct and Derived Demand
Direct demand refers to demand for goods meant for final consumption.
It is the demand for consumer goods. By contrast, derived demand refers
to the demand for goods which are needed for further production. Thus,
demand for an input is a derived demand.
2. Domestic and Industrial Demand
In case of certain industrial raw materials, which are also used for
domestic purpose, this distinction is very meaningful. The example of the
refrigerator can be given to distinguish between the demand for domestic
consumption and demand for industrial use.
3. Autonomous and Induced Demand
When the demand for a product is tied to the purchase of some parent
product, its demand is called induced demand. For example, demand for
cement is induced by the demand for housing. Thus, demand for all
producers’ goods is induced demand. In addition, even in the realm of
consumer goods, we may think of induced demand. Like complementary
goods, bread and butter. Autonomous demand on the other hand is not
induced. Unless a product is totally independent of the use of other
products, it is difficult to talk about autonomous demand. In present
world of dependence, there is hardly any autonomous demand. No body
consumes just a single commodity but a bundle of commodities. Even
then all direct demands may loosely be called autonomous. In context of
econometric estimates of demand, this distinction is used to identify the
determinants of demands. For example in Dx = a-bPx, “a” represents the
autonomous part which captures the effect of all non-price factors,
whereas “b” represents the induced part as Dx is induced by Px, given the
size of “b”.

4. Perishable and Durable Goods Demand

Both consumers’ goods and producers’ goods are further classified into
perishable/ non-durable/single use goods and durable/non-
perishable/repeated use goods. The former refers to final output like
bread or raw material like cement which can be used only once. The
latter refers to items like shirt, car or machines which can be used
repeatedly.

5. New and Replacement Demand

If the purchase or acquisition of an item is meant as an addition to stock,
it is new demand. It the purchase of an item is meant for maintaining the
old stock of capital/ asset intact, it is replacement demand.
6. Final and Intermediate Demand
The demand for semi-finished products, industrial raw materials and
similar intermediate goods are all intermediate demands. The demand for
goods that is made by consumer for final consumption is final demand.
Like demand for car is a final demand while demand for steel by car
industry is an intermediate demand.

7. Individual and Market Demand

This distinction is often employed by the economist to study the size of
buyers’ demand, individual as well as collective. A market is visited by
different consumers, consumer differences depending upon factors like
income, sex etc. they all react differently to the prevailing market price of
a commodity. For example, when the price is very high, a low -income
buyer may not buy anything though a high-income buyer may buy
something. In case we distinguish between demand of an individual
buyer and that of market, which is the aggregate of individual demands.

8. Company (Firm) and Industry Demand

An industry is the aggregate of firms (companies). Thus, the company’s
demand is similar to an individual demand, whereas the industry’s
demand is similar to the aggregate total demand. Demand for engineers
by automobile industry is an industry demand, while demand for
engineers by Hero Honda is company demand.

Elasticity of Demand
Economists and businessmen often concerned with the responsiveness
of one variable to change in some other variable. The law of demand
states that a change in the price of a commodity causes a change in the
quantity demanded. The change is in the reverse direction. This inverse
relationship indicated by the law of demand is a qualitative one as it only
indicates the direction in which the change would take place. It does not
provide us the precise information about the degree of change. The
concept of elasticity of demand explains degree of change in quantity
demanded due to change in price.
The concept of elasticity in economics is borrowed from physics. In
physics, it is supposed to show the reaction of one variable with respect
to change in other variables on which it is dependent. The elasticity may
be defined as the percentage change in some dependent variable given a
one per cent change in independent variables, ceteris paribus. There are
as many elasticities of demand as its determinants. The most important of
these elasticities are: (1) price elasticity, (2) income elasticity, and (3)
cross elasticity.

Price Elasticity
It is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the change in the price is very small, we use
as a measure of the responsiveness of the demand the point elasticity of
demand. If the changes in the price are not small we use the arc elasticity
of demand as the relevant measure.

Ep = proportional change in demand / proportional change in price

Ep = - ΔQ/ΔP. P/Q

Where:
Ep = price elasticity, p = initial price, Q = initial quantity demanded, and
Δ = change.

Three points must be noted at this stage:

1. Price elasticity is a ratio of marginal demand (ΔQ/ΔP) to average

demand (Q/P).
2. Elasticity is a unitless or dimensionless concept. It is just a pure
number. Consider the relative variation of the quantity ΔQ/Q. we can
not alter the ratio simply by changing the unit of measure as both the
numerator and denominator are expressed in the same unit. The same
is true to ΔP/P.
3. The coefficient of elasticity is ordered according to absolute value as
opposed to algebraic value. Hence, an elasticity of –2 is greater than
an elasticity of –1 even though algebraically the opposite would be
true.

Thus, ep = - ΔQ/ΔP. P/Q

If demand curve is linear, then Q = a - bP

Its lope is ΔQ/ΔP = -b, substituting it in the formula of elasticity, we get
ep = -b. P/Q, which implies that elasticity changes at the various points of
demand curve. Graphically, the point elasticity of linear demand curve is
 shown by the ratio of the segment of the line to the right and to the left of
the particular point.
Thus, ep = lower segment/ upper segment.
This formula is used when ep is measured at a particular point. When ep
is measured on an arc, the following formula would be used-

Ep = - ΔQ/ΔP. (P1 + P2) / (Q1+Q2)

Where, P1 is initial price and P2 is new price and Q1 is initial quantity

and Q2 is new quantity.

Degrees of Price Elasticity of Demand

Following are the degrees of price elasticity of demand:

1. Perfectly elastic demand (ep = ∞)

2. Perfectly inelastic demand (ep = 0)
3. Highly elastic demand (ep > 1)
4. Unitary elastic demand (ep = 1)
5. Less elastic or inelastic demand (ep < 1)
A good or service is considered to be highly elastic if a slight change
in price leads to a sharp change in the quantity demanded. Usually these
kinds of products are readily available in the market and a person may not
necessarily need them in his or her daily life. On the other hand, an inelastic
good or service is one whose changes in price witness only modest changes
in the quantity demanded, if any at all. These goods tend to be things that are
more of a necessity to the consumer in his or her daily life.
Interpretation of Elasticity Coefficients
The sign of the coefficient shows the directional change. The negative
sign shows inverse relationship between the price and the quantity
demanded. As already stated, for interpretation point of view, coefficient
value is considered in absolute figure. The interpretation of ep = -1.5 would
be that a 1 percent increase in price would lead to a 1.5% decline in quantity
demanded. Or if the price falls by 1 percent, quantity demanded would
increase by 1.5%. If the elasticity coefficient is less than one, the demand is
less elastic or inelastic. If it is equal to one, demand is unitary elastic. If ep 
one, the demand is more elastic. On the basis of estimated coefficient of
price elasticity, nature of a commodity or a service can be identified. For
instance, if a commodity is price-inelastic, it would be an essential
commodity. For luxury products, ep would be greater than one.
Measurement of Price Elasticity of Demand
1. Total Outlay Method
This method to measure the elasticity of demand was used by
Marshall. In this method we compare the change in the total expenditure
incurred by a consumer before and after the variation in price. The elasticity
of demand is expressed in ways: (i) unity; (ii) greater than unity; and (iii)
less than unity. Elasticity is considered unity when the total expenditure
remains the same even after a change in price. Elasticity of demand is said to
be greater than unity when with the fall in price the expenditure increases or
as the price increases, the expenditure falls. Elasticity is considered to be
less than unity when the amount spent increases with the rise in price and
decreases with the fall in price. These three categories of elasticity have
been shown in the following table.

Case Price Demand Total Outlay Elasticit

No. (Px in (Qx in (Px.Qx in y (ep)
Rs.) Unit) Rs.)
1 10 4 40 ep > 1
5 12 60
2 10 4 40 ep = 1
5 8 40
3 10 4 40 ep < 1
5 6 30

2. Geometrical Method
When elasticity is measured at a point on a demand curve, it is called
point elasticity. It is measured at the point by the ratio of the lower part of
the linear demand curve to the upper part. If demand curve is non-linear,
a tangent is to be drawn at the point on demand curve where elasticity is
to be measured. Then, Ep is measured by dividing the lower segment of
the tangent line from its upper segment.

3. Percentage Method
When calculating elasticity of demand with the help of percentage
method, we compare percentage change in quantity to the percentage
change in price. The elasticity, according to this method, is the
percentage change in the quantity demanded to the percentage change in
the price changed. Thus, the price elasticity becomes ratio of a relative
change in the quantity to a relative change in price.

Ep = -ΔQ/ΔP. P/Q

4. Arc Method
The measurement of price elasticity of demand between any two
points on a demand curve is known as arc elasticity. When elasticity is to
be measured not on a point but on an arc, instead of initial price and
initial quantity, average of both the prices and both the quantities is
considered.

Ep = -ΔQ/ΔP. (P1 + P2) / (Q1+Q2)

Determinants of Price Elasticity(ANP NPPT)

1. Availability of substitutes
If the commodity has many close substitutes, its demand will be
highly price-elastic. The reason is that if the price of such a commodity
goes up, consumers will start consuming other substitutable goods.

2. Nature of Goods
Price elasticity also depends on the nature of goods. Essential goods
have inelastic or relatively less elastic demand, while luxury products
have relatively more elastic demand.

3. Position of a commodity in the budget

Budget position means the fraction of total expenditure devoted to a
single commodity. The elasticity of a commodity on which a small
percentage of income is spent is relatively lower.

4. Number of uses of a commodity

The more uses a commodity can be put to, the more elastic its demand
would be. If the price of such a commodity increases, consumers will use
it only in a few applications.
5. Postponement of Use
 The goods the purchase and use of which can be deferred have a high
elastic demand. When price has risen and demand cannot be postpone,
that will make demand less responsive to price rise than when demand
can be postpone.

6. Price expectation of Buyers

When the price of a product has fallen and the buyers expect it to fall
further, then they will postpone buying the good and this will make
demand less responsive.

7. Time factor in adjustment of consumption pattern

In short run, it is difficult to change habits. Hence, the short run
demand is less responsive to price change. The longer the time allowed
for making adjustment in consumption pattern, the greater will be the
elasticity.

Income Elasticity of Demand

Income elasticity of demand measures the degree of responsiveness of
quantity demanded of a commodity with respect to the change in the
level of income of a consumer, other things remaining constant.

Ei = ΔQ/ΔY. Y/Q

Where:
Ei = income elasticity, Y =initial income, Q = initial quantity
demanded, and Δ = change.

If income elasticity is to be measured on an arc, average of both

incomes and both the quantities will be considered in place of initial
income and initial quantity.

Ei = ΔQ/ΔY. Y1+Y2/Q1+Q2

Unlike Ep which is always negative, Ei is generally positive.

However, in case of inferior and Giffen goods, it is negative. The reason is
that when income increases, consumers switch over to the consumption of
superior substitutes. For all normal goods, Ei is positive though the degree
of elasticity varies in accordance with the nature of commodities. Consumer
goods of three categories, viz., necessities, comforts and luxury have Ei
 less than one , equal to one, and more than one, respectively. The income
elasticity of demand for different categories of goods may, however, vary
from household to household and from time to time, depending upon the
choice and preference of the consumers, level of consumption and income,
and their susceptibility to demonstration effect.
Understanding of Income elasticity of demand is significant in
production planning and management in the long run. It is useful in demand
forecasting. It is generally believed that the demand for goods and services
increases with the increase in GNP depending on the marginal propensity to
consume. This may be true in the context of aggregate demand, but not
necessary for a particular product. It is quite likely that increase in GNP
flows to a section of consumers who do not, or are not in a position to
consume the product in which a businessman is interested. For instance, if
the major proportion of increased GNP goes to those who can afford a car,
the growth rate of GNP can not be used to calculate income elasticity of
demand for motorcycles.

Cross Elasticity of Demand

The cross elasticity is the measure of responsiveness of demand for a
commodity to the changes in the price of its substitutes or complementary
goods.

Ec = ΔQx /ΔPy. Py/Qx

Where:
Ec = cross elasticity, Qx = initial quantity of x commodity, Py = initial
price of y commodity, Δ = change.

If Ec is to be measured on an arc, above formula is modified as:

Ec = ΔQx /ΔPy. Py1+ Py2 / Qx1+Qx2

Sign of Ec will be negative in case of complementary goods and positive

in case of substitutive goods. An important use of Ec is to identify the extent
of substitutability between the two goods. Its coefficient helps the
businessman in fixing the price of its product. If Ec of a product is greater
than 1, it would not be advisable to increase the price; rather reducing the
price may prove beneficial. In case of complementary goods, demand
projection can be made by calculating the Ec. For instance, if elasticity of
demand for car with respect to price of petrol is greater than one, it would
suggest that the company has to invest more on R&D to make the car model
more fuel-efficient to enhancing the demand.

Practical Uses of Elasticity

The concept is useful to both business as well as government
managers. It helps the sales manager in fixing the price of his product. The
concept is also important to the economic planners of the country. In trying to
fix the production targets for various goods in a plan, a planner must estimate
the likely demand for goods at the end of the plan. This requires the
understanding of income elasticity of demand.
The price elasticity of demand as well as cross elasticity of demand
would determine the substitution between goods and hence useful in fixing the
output-mix. The concept is also useful to policy makers in particular
determining taxation policy, minimum wage policy, stabilization programmes
for agriculture and price policy for various other goods where administered
prices are used. The main uses of the concept are:

1. In taxation - if Ep<1, government can increase tax on such commodities

to increase tax revenue. But government does not do so because India
is a democratic country.

2. In Monopoly Price

3. In International trade

4. In Production

5. In Distribution