Chapter-2

Theory of Demand, Supply and Equilibrium Price

Q. What is Demand?
Demand is the quantity of goods and services that consumers are willing and able to buy at the price prevailing per period of
time. In the words of J. Harvey, “Demand in economics is the desire to possess something and the willingness and the ability to
pay a certain price in order to possess it”. Thus, the elements of demand are :(i) desire to have a good or service, (ii) the good or
service has a price, (iii) purchaser’s ability to pay the price, (iv) willingness to pay the price, and (v) per unit of time (per day, per
week).
Q. What is Demand Function?
A function is a mathematical expression that establishes the relationship between two variables; it shows how one variable
affects the other. To put this in another way, a function shows the relationship between two or more variables, generally known
as the dependent and independent variables. Determinants of demand are the elements that cause increase or decrease in
demand. Common determinants of demand are price of the commodity, income of the consumer, price of related goods
(substitute and complementary goods), consumers’ taste and preferences.

Symbolically, Qx=ꝭ(Px) ……………(i)

Q. Explain the Types of Demand Function

Demand function differs on the basis chosen for analysis. On the basis of functional form, we can mention two types of demand
function. A functional form refers to the algebraic structure of the relationship between a dependent variable and explanatory
variable(s). The two forms of demand function are linear and nonlinear.

1. Linear Demand Function: If the slope of demand curve remains constant throughout its length, it is called linear demand
function. The simplest form of the linear demand function is given by the equation:
DX = a – b PX . . . . (2.1)
where, Dx = demand for commodity X, PX = price of X
a = autonomous demand, b = slope of demand curve

The key point to note in equation (2.1) is that the demand curve will be a straight line as shown in Figure 2.1

FIGURE 2.1: Linear Demand Curve

The slope of a line or curve is a measure of how steep it is. The slope of a line is measured by “rise over run”, the change
in the y-variable between two points on the line divided by the change in the x-variable between those same two points.
Mathematically,

Rise Change in y y y2 – y1
Slope = = = =
Run Change in x x x2 – x1
 In the formula, the symbol  (the Greek uppercase delta) stands for “change in”. When a variable increase, the change
in the variable is positive; when a variable decrease, the change in that variable is negative.

The slope of the curve is positive when the rise (the change in the y-variable) has the same sign as the run (the change
in the x-variable). The slope of the curve is negative when the rise (the change in the y-variable) and run (the change in
the x-variable) have different signs.

The slope is negative, indicating that the curve is downward sloping. Moreover, the slope between A and B is the same
as the slope between B and C, and G and H; the slope will be the same between C and E, E and F, and F and G, making
this a linear curve. The slope of the linear curve is constant: it is the same despite where it is measured along the curve.
Thus, the slope of the straight-line demand curve is constant.

Individual linear demand function

Individual demand function refers to the functional relationship between the demand for a good by an individual and
the factors affecting individual demand. It is expressed as:
d
QX = a0 - a1Px+a2PR+a3Y+a4TP+a5A+a6E . . . (2.2)
d
Where, QX = quantity demanded for commodity X; PX = price of the given commodity X; PR = price of related goods (i.e.,
price of substitute and complementary goods); Y = income of the consumer, TP = taste and preferences; A = advertising
expenditures; E = expectation of change in price in future; ‘f’ is a function of or depends upon; a is an intercept/constant;
and a1, a2, a3, a4, and a5 are the parameters of demand functions. These parameters can be estimated by collecting data
on the dependent and several independent variables included in the equation.

Linear market demand function

Market demand function refers to the functional relationship between market demand for a product and factors
affecting market demand. Market demand is affected by all factors affecting individual demand. In addition, it is also
affected by the size and composition of population. Mathematically, a linear market demand function linking quantity
demanded with its determinants can be written as:

DX = b0 – b1PX + b2PR + b3Y + b4TP + b5A + b6E + b7PoP+b8S . . . . (2.3)

d
where, QX = quantity demanded for commodity X; PX = price of given commodity X; PR = price of related goods (i.e.,
price of substitute and complementary goods); Y = income of the consumer, TP = taste and preferences; A = advertising
expenditures; E = expectation of change in price in future; PoP = Size and composition of population; S = season and
weather; f stands for “is a function of or depends upon”; b0 is an intercept term; b1, b2, b3, b4, b5, b6 , b7 and b8 are the
parameters of demand functions. These parameters can be estimated by collecting data on the dependent quantity
demanded (Q) and several independent variables of the left-hand side.

2. Non–Linear Demand Function: A demand function is said to be non–linear if the slope of demand curve is not the same
between every pair points on the curve. The graph of it will be a curve (a line which gradually deviates from being
straight for some or all of its length) or rectangular hyperbola. One of the types of the non–linear demand function can
mathematically be expressed as:
–b
DX = aPX . . . (2.4)

where, Dx = demand for commodity X, PX = price of X , a = autonomous demand,

b = slope of demand curve ; a >0, b > 0.
 A non-linear demand curve is shown in Figure 2.2.

FIGURE 2.2: Non-linear Demand Curve

The slope of the non–linear demand curve AE is different at different points.

The slope is negative, indicating that the curve is downward sloping. More importantly, the slope between A and B is
different from the slope between B and C, and C and E. Thus, the slope of a non-linear demand curve is non-constant;
it is different along the demand curve.

Q. Explain the Determinants of Demand

There are a number of factors due to which demand for a good or service differs from place to place, time to time and
person to person. Those factors that cause increase or decrease in the demand for a good or service are known as
determinants of demand. The following are the major factors affecting the demand for a good or service:
1. Price of the Commodity: Price of a good or service is the main determinant for its demand. Other things remaining the
same, quantity demanded is higher at a lower price and it is lower at higher price.
2. Income: Income level of the consumer determines the ability to pay of the buyers. So, at a higher level of income
demand will be high for luxurious and normal goods and low for inferior goods and vice versa.
3. Prices of substitute and complementary Goods: For substitute goods (those that can be used to replace each other),
price of a substitute and demand for the other good are directly related (assuming that price of one of them does not
change). For example, if the price of coffee rises, the demand for tea should increase. For complement goods (those
that can be used together), price of complement and demand for the other good are inversely related. For example,
the increase in the price of Pen leads to a decline in the quantity demanded for Ink and vice versa.
4. Taste and preferences: If taste and preferences of consumers are changed in favour of a particular good, then the
demand for that good will be higher and vice versa. This means if consumer prefers a good, then demand for that good
will be high and vice versa.
5. Size and composition of population: Demand for a good will be higher in case of larger population and favourable
composition of population. If the size of population is small, then the demand will be lower. Similarly, the composition
of the population is also an important determinant of demand. For example, teenagers usually prefer Pulsar Bikes.
6. Advertisement: Advertisement is another main determinant of demand because advertisement provides information
to consumers about the product; it sometimes causes change in consumers’ preference due to which they may buy
more quantity of the product. At the same time advertisement creates attraction towards the advertised products and
pressures to purchase more quantity of the product.
7. Price expectation: If people expect price rise of a product in the future, then the demand for the product will be higher
in the present. The opposite will happen in demand if consumers expect price fall in the future.
8. Fear of shortage: If people have fear of shortage of good in the future, then the demand for the good will be higher in
the present.
9. Seasonal factors: Demand for some products is different at different times of the year. One of the causes is weather;
for example, demand for woollen clothes is higher in the winter than in the summer.
10. Custom and tradition: Difference in demand may occur because of custom and tradition. Demand for goods related to
annual festivals, such as buying gifts at Deepawali, Vijaya Dashami is higher in Nepal.
 Q. Explain Movement along a Demand Curve and Shift in a Demand Curve
Economists often make a distinction between (1) change in quantity demanded, and (2) change in demand. A “change in quantity
demanded” is not the same as a “change in demand.” We need to be clear on these important and possibly confusing
terminologies.

A change in quantity demanded is a change in the specific quantity of a good or service that buyers are willing and able to buy
at a given price. To refer to Paul Krugman and Robin Wells, “A movement along the demand curve is a change in the quantity
demanded of a good arising from a change in the good’s price”. This indicates that movement along a demand curve is the
graphical representation of the effect of a change in price on the quantity demanded, other determinants of demand remaining
the same. Movement along the demand curve indirectly explains the same concept as explained by the law of demand. Other
determinants of demand assumed constant include buyers’ income, buyers’ preferences, other prices, buyers’ expectations, and
number of buyers.

The concept of movement along the demand curve is illustrated in Figure, in FIGURE
FIGURE 2.9:2.8: Movement
Movement along aalong
Demanda Curve
demand curve

which price and quantity demanded are represented on the vertical axis and Y

horizontal axis respectively. DD1 is the demand curve. Suppose initially the Con traction in
D
consumer is on point E1 on the demand curve. Initial price is P1 and corresponding dem and
P2
demand is Q1. E2

Price
If price of the good rises from P1 to P2, quantity demanded decreases from Q1 to P1
E1 Expan sion in
Q2. The new point on demand curve is 'E2'. It shows contraction or a decrease in dem and
quantity demanded. On the other hand, if there is fall in price from P 1 to P3, P3
E3
D1
quantity demanded increases from Q1 to Q3. The new point on the demand curve
O
is at 'E3'. It shows expansion or increase in quantity demanded. Therefore, the Q2 Q1 Q3
X

change in price–quantity combination from E1 to E2 or from E1 to E3 due to change Qu an tity Dem and ed
in the price of the commodity is called movement along the same demand curve. Figure 1.9: Movement along dem and curve

Shift in Demand Curve

Demand is a numerical table of quantities of a good that will be bought per unit of time at various prices, other things remaining
constant. In graphical terms, demand refers to the entire demand curve. Demand tells us how much will be bought at various
prices. Change in demand graphically means shift in the entire demand curve. Change in demand occurs because the consumer’s
state of mind about buying the product has been changed in response to a change in one or more of the determinants of demand
other than price. As “demand” is a schedule or curve, a “change in demand” means a change in the schedule and shift of the
curve.

Therefore shift in demand curve is the graphical representation of the effect of change in demand due to any factor other than
the price of the product. Important shift-factors of demand include society’s income, the prices of other related goods, tastes of
consumer, expectations of consumers, and taxes and subsidies. When there is change in one or more of the demands shifting
factors, demand for a product increases or decreases. If the demand curve shifts to the right, there is increase in demand; and if
the demand curve shifts to the left, there is decrease in demand. That is, increase in demand implies rightward shift in the
demand curve whereas decrease in demand implies leftward shift in the demand curve.

The concept of shift in the demand curve is illustrated in Figure, in which price FIGURE 2.10: Shift in
FIGURE 2.9:Demand Curve
Shift in demand curve

is represented on the Y–axis and quantity demanded is on the X–axis. Suppose Y

price prevailing in the market is P1 and the initial demand curve is DD1.At price
P1 with demand curve DD1 quantity demanded is Q1. Now suppose, for instance,
Decrease in demand
there is increase in the number of consumers due to in-migration. This causes D D D
Price

the demand curve to shift rightward to the position DD2, the result is the In crease in demand
increase in demand from Q1 to Q2. On the other hand, if the demand curve shifts
P1
towards the left to the position DD3, suppose due to reduced preferences of
D3 D1 D2
consumer towards the product, there is decrease in demand from Q1 to Q3.
O X
Q3 Q1 Q2
Qu an tity deman ded
Q. Explain the causes responsible for shifting demand curve.
The change in quantity demand causes shift in demand curve. The factor that bring changes in quantity demand other
than the change in price they are as follows:

1. Income of the consumers: The demand for a commodity changes along with change in income of the consumers.
Generally, if there is increase in income of the consumers, demand for normal goods increases and the demand curve
shifts towards right. If there is decrease in income, demand tends to decrease and demand curve shifts towards left.
But, in case of inferior goods, demand decreases with increase in income and vice–versa.

2. Price of related goods: Change in prices of substitute and complementary goods shifts the demand curve. For example,
Tea and Coffee is a pair of substitute goods. If the price of Tea rises, then demand for Tea decreases but the demand
for coffee increases which causes the rightward shift of the demand curve of coffee; but the demand curve of coffee
will shift leftward if there is fall in price of Tea. Likewise, Car and Petrol are complementary goods. A rise in the price of
car causes the demand for petrol to fall. As there is fall in the demand for petrol, the demand curve of petrol shifts
towards left, and in the case of rise in demand for petrol due to fall in car prices, the demand curve of petrol will shift
to the right.

3. Consumers taste and preferences: If the consumers taste and preferences increase towards any commodity, then it
increases demand for that product and shift the demand curve shift towards right. But if consumers show lower
preference towards any commodity, then it decreases the demand and causes the demand curve to shift towards the
left.

4. Consumer Expectations: It is not that changes in the current values of variables may change the demand for a good. It
is also true that changes in people’s expectations about future values of variables may change demand. For example, a
newly formed expectation of higher future prices may cause consumers to buy now in order to overcome the
anticipated price rises, thus increasing current demand. Demand curve shifts to the right.

Similarly, a change in expectations about future income may encourage consumers to change their current spending. If
someone is surer to get employment in the near future, he/she would increase current demand for certain goods even
by borrowing money. Or workers who become fearful of losing their jobs may reduce their demand for certain goods
or services (for example, vacation travel).

5. Size of population: Change in the size of the population brings significant change in quantity demanded. If there is
increase in the size of population, it increases the demand for goods and services and the demand curve shifts towards
right. But, decrease in population size causes demand curve to shift towards left.

6. Taxes and subsidies: Taxes levied on consumers increase the cost of goods to consumers and therefore reduce demand
for those goods. Subsidies to consumers have the opposite effect. When central or state governments introduce tax-
free weeks just before the start of new session of schools every year, consumers load up on products to avoid sales
taxes. Demand for retail goods rises during the tax holiday.

There are many other factors in addition to the ones listed above. In fact, anything, apart from the price of the good
itself that affects demand is a shift factor.

Date: 5 May 2021

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