Theory of Demand

• People demand goods because it satisfies the wants of the people.

• Utility is want satisfying power of the commodity.

• Utility is subjective, as it varies from person to person and different

people derives different utility from the different .
• Utility is ethically neutral. For eg: alcohol may be harmful but it
possess utility to the people whose wants are satisfied.
Meaning of demand
• Economists mean demand of the goods by consumers. It is attitude
and reaction towards that commodity.

• Demand for a commodity is the amount of it that a consumer will

purchase or will be ready to take off from market at various given
prices in a period of time.
• This implies both willingness and ability to pay.
Demand for a good is determined by
various many factors:
• Tastes and desires of consumer
• Income of consumer
• Prices of related goods, substitutes and complements.

Change in any one of these factor leads to change in demand for a

good.
Individual vs market demand
• Market demand is the sum total of demand s the individual
consumers who purchase the commodity in the market.
 Law of demand
• According to the law of demand, other things being equal if price of a
community falls, the quantity demanded of it will rise, and if price of
the commodity rises, its quantity demanded will decline.
• Thus according to law of demand there is inverse relationship
between price and quantity demanded, other things remaining
constant. ( Other things may be the consumer taste and preferences,
income of the consumer and the price of related goods.
• Thus demand curve is a graphic statement or presentation of
quantities of a good which will be demanded by the consumer at
various possible prices at a given moment of time.

• Since more is demanded at a lower price and less is demanded at a

higher price , the demand curve slopes downward to the right which
describes inverse price- demand relationship.
As a result of the fall in the price of a commodity, consumer’s real
income or purchasing power increases.
This increase in real income induces the consumer to buy more of that
commodity. This is called income effect of the change in price of the
commodity.
When price of commodity falls, it becomes relatively cheaper than
other commodities. This induces the consumer to substitute the
commodity whose price has fallen for other commodities which have
now become relatively dearer. As a result of substitution effect, the
quantity demanded of a commodity whose price has fallen rises.
Exceptions to the law of demand
• Goods having prestige value: Veblen Effect
Thorstein Veblen propounded the doctrine of conspicuous
consumption. According to Veblen some consumers measure utility of a
commodity entirely by price, i.e.greater price means greater utility .
Like diamons are considered to be the prestige goods for upper strata
of the society. This is called Veblen effect.
 Giffin Goods
Sir Robert Giffin observed that when price of bread increased, the low
paid British workers purchased more bread which is contrary to law of
demand. As they could not afford to purchase as much meat as before ,
thus they substituted meat for bread in order to maintain the intake of
food as British workers consumed mainly a diet of bread.
 Exceptions to law of demand
• Suppose there is shortage of rainfall this year due to which it is
predicted that the price of grains will rise in future. So, even if the
price of foodgrains is higher at present, people will buy and store ,
hence demand will increase.
• Demand for commodity increase during times of prosperity due to
increase in income of the people, and demand for commodities
decrease in times of depression due to fall in income of the people.
• Some people buy high priced items more than the low price because
they consider it to be superior even if there is no significant difference
in quality.
 Determinants of Demand
• Tastes and preferences of the consumers
• Incomes of people
• Changes in the price of related goods
• The number of consumers in the market
• Change in the propensity to consume
• Consumer expectation with regard to future prices
• Income distribution
Law of Supply
• The law of supply states that a higher price leads to a higher quantity
supplied and lower price leads to lower quantity supplied.
 Determination of price
• Determination of price means cost of goods sold in free market.
In free market, forces of demand and supply determine the prices.

The Government does not interfere in determination of price.

However , in some cases , Govt, May intervene in determining the
prices.
For eg: Government has fixed the minimum selling price for the wheat.
Factors affecting determination of prices.
• Product Cost:
It is the most important factor that decide the price. It incudes fixed
cost, variable cost and semi- variable cost incurred through production,
distribution and selling of product.
Fixed cost is which remain fixed at all levels of production or sales. Eg:
Rent, salary etc.
• Variable costs attribute to cost directly related to levels of production
or sales. Eg: Cost of basic material, apprentice cost etc.

• Semi variable takes into account costs which change with level of
activity but not in direct proportion.
• The utility and demand
Normally end user demands more units of product when price is low and
vice versa.

On the other hand, if demand is elastic, little variation may result in large
changes in quantity demanded.
While when it is inelastic, change in price does not affect demand
significantly.
In addition, buyer is ready to pay till the time he perceives utility is at least
equal to price paid.
• The extent of competition in market
A firm can fix any price if competition is low. But when there is
competition, price is fixed keeping in mind the price of substitute goods.

• Government and legal regulations

Firms which have monopoly in market, charge high price for products.
To protect interest of public, government intervenes and regulate the
prices of commodities. For this purpose it declares some products as
indispensable products like life saving drugs
• Pricing objectives
Profit maximization, market share leadership, , survival in competitive
market, attaining product quality leadership are pricing objective of an
enterprise.
By large, firm changes higher prices to cover high quality and high cost
if it is backed by above objective.
• Marketing methods used
Range of marketing methods like quality of salesman, marketing, type
of wrapping, patron services etc also affects prices of manufactured
products. For eg: organization will charge sky- scraping revenue if it is
using the classy material for wrapping products.
Determination of equilibrium price
• The price that makes demand equivalent to supply is called
equilibrium price.

• Graphically, equilibrium price is a point where demand curve and

supply curve meet or intersect.
• Price where no unsold stock left neither any demand unfulfilled .
Hence it is also called market clearing price.
• Other things remaining same, when prices falls below equilibrium
price , demand increases and supply decreases.

• There arises shortage of goods which in turn increases the price to

equilibrium price.
• Similarly when price rises above equilibrium price, demand decreases
and supply increases. There arises surplus of goods which in turn
decreases price to equilibrium price.
• Thus market restores equilibrium of its own.
• However, the prices are not determined only by forces of demand and
supply. Other factors such as price of substitute goods, price of
related goods, government policies, competition in market etc., also
plays an important role in determination of prices.
The Shift in Demand and Supply

Definitely, if there is any change in supply, demand or both the market

equilibrium would change. Let’s recollect the factors that induce
changes in demand and supply:
• Shift in Demand
• The demand for a product changes due to an alteration in any of the
following factors:
• Price of complementary goods
• Price of substitute goods
• Income
• Tastes and preferences
• An expectation of change in the price in future
• Population
• Shift in Supply
• The supply of product changes due to an alteration in any of the following
factors:
• Prices of factors of production
• Prices of other goods
• State of technology
• Taxation policy
• An expectation of change in price in future
• Goals of the firm
• Number of  firms
Now let us study individually how market equilibrium changes when
only demand changes, only supply changes and when both demand
and supply change.
When only Demand Changes

• A change in demand can be recorded as either an increase or a

decrease. Note that in this case there is a shift in the demand curve.
• Increase in Demand
• When there is an increase in demand, with no change in supply, the
demand curve tends to shift rightwards. As the demand increases, a
condition of excess demand occurs at the old equilibrium price. This
leads to an increase in competition among the buyers, which in turn
pushes up the price.
Of course, as price increases, it serves as an incentive for suppliers to
increase supply and also leads to a fall in demand. It is important to
realize that these processes continue to operate until a new equilibrium
is established. Effectively, there is an increase in both the equilibrium
price and quantity.
Decrease in Demand

• Under conditions of a decrease in demand, with no change in supply,

the demand curve shifts towards left. When demand decreases, a
condition of excess supply is built at the old equilibrium level. This
leads to an increase in competition among the sellers to sell their
produce, which obviously decreases the price.
• Now as for price decreases, more consumers start demanding the good
or service. Observably, this decrease in price leads to a fall in supply
and a rise in demand. This counter mechanism continues until the
conditions of excess supply are wiped out at the old equilibrium level
and a new equilibrium is established. Effectively, there is a decrease in
both the equilibrium price and quantity.
When only Supply Changes

• Increase in Supply
• When supply increases, accompanied by no change in demand, the
supply curve shift towards the right. When supply increases, a
condition of excess supply arises at the old equilibrium level. This
induces competition among the sellers to sell their supply, which in
turn decreases the price.
• This decrease in price, in turn, leads to a fall in supply and a rise in
demand. These processes operate until a new equilibrium level is
attained. Lastly, such conditions are marked by a decrease in price and
an increase in quantity.
Decrease in Supply

• When the supply decreases, accompanied by no change in demand,

there is a leftward shift of the supply curve. As supply decreases, a
condition of excess demand is created at the old equilibrium level.
Effectively there is increased competition among the buyers, which
obviously leads to a rise in the price.
• An increase in price is accompanied by a decrease in demand and an
increase in supply. This continues until a new equilibrium level is
attained. Further, there is a rise in equilibrium price but a fall in
equilibrium quantity.
When both Demand and Supply Change

• Generally, the market situation is more complex than the above-

mentioned cases. That means, generally, supply and demand do not
change in an individual manner. There is a simultaneous change in
both entities. This gives birth to four cases:
• Both demand and supply decrease
• Both demand and supply increase
• Demand decreases but supply increases
• Demand increases but supply decreases
Video
Both Demand and Supply Decrease

• The final market conditions can be determined only by a deduction of

the magnitude of the decrease in both demand and supply. In fact,
both the demand and supply curve shift towards the left. Essentially,
there is a need to compare their magnitudes. Such conditions are
better analyzed by dividing this case further into three:
• The decrease in demand = decrease in supply
• When the magnitudes of the decrease in both demand and supply are
equal, it leads to a proportionate shift of both demand and supply
curve. Consequently, the equilibrium price remains the same but
there is a decrease in the equilibrium quantity.
• The decrease in demand > decrease in supply
When the decrease in demand is greater than the decrease in supply,
the demand curve shifts more towards left relative to the supply curve.
Effectively, there is a fall in both equilibrium quantity and price.
• The decrease in demand < decrease in supply
In a case in which the decrease in demand is smaller than the decrease
in supply, the leftward shift of the demand curve is less than the
leftward shift of the supply curve. Notably, there is a rise in equilibrium
price accompanied by a fall in equilibrium quantity.
Both Demand and Supply Increase

In such a condition both demand and supply shift rightwards. So, in

order to study changes in market equilibrium, we need to compare the
increase in both entities and then conclude accordingly. Such a
condition is further studied better with the help of the following three
cases:
• The increase in demand = increase in supply
• If the increase in both demand and supply is exactly equal, there
occurs a proportionate shift in the demand and supply curve.
Consequently, the equilibrium price remains the same. However, the
equilibrium quantity rises.
• The increase in demand > increase in supply
• In such a case, the right shift of the demand curve is more relative to
that of the supply curve. Effectively, both equilibrium price and
quantity tend to increase.
• The increase in demand < increase in supply
• When the increase is demand is less than the increase in supply, the
right shift of the demand curve is less than the right shift of supply
curve. In this case, the equilibrium price falls whereas the equilibrium
quantity rises.
Demand Decreases but Supply Increases

This condition translates to the fact that the demand curve shifts
leftwards whereas the supply curve shifts rightwards. As they move in
opposite directions, the final market conditions are deduced by
pointing out the magnitude of their shifts. Here, three cases further
arise which are as follows:
• The decrease in demand = increase in supply
• In this case, although the two curves move in opposite directions, the
magnitudes of their shifts is effectively the same. As a result, the
equilibrium quantity remains the same but the equilibrium price falls.
• The decrease in demand > increase in supply
• When the decrease in demand is greater than the increase in supply,
the relative shift of demand curve is proportionately more than the
supply curve. Effectively, both the equilibrium quantity and price fall.
• The decrease in demand < increase in supply
• Here, the leftward shift of the demand curve is less than the
rightward shift of the supply curve. It is important to realize, that the
equilibrium quantity rises whereas the equilibrium price falls.
Demand Increases but Supply Decreases

Similar to the aforementioned condition, here also the demand and

supply curve moves in the opposite directions. However, the demand
curve shift towards the right(indicating an increase in demand) and the
supply curve shift towards left(indicating a decrease in supply). Further,
this is studied with the help of the following three cases:
Increase in demand = decrease in supply

When the increase in demand is equal to the decrease in supply, the

shifts in both supply and demand curves are proportionately equal.
Effectively, the equilibrium quantity remains the same however the
equilibrium price rises.
Increase in demand > decrease in supply

In this case, the right shift of the demand curve is proportionately more
than the leftward shift of the supply curve. Hence, both equilibrium
quantity and price rise.
Increase in demand < decrease in supply
• If the increase in demand is less than the decrease in supply, the shift
of the demand curve tends to be less than that of the supply curve.
Effectively, equilibrium quantity falls whereas the equilibrium price
rises.
 Elasticity

Elastic is a term used in economics to describe a change in the behavior

of buyers and sellers in response to a change in price for a good or
service. In other words, demand elasticity or inelasticity for a product
or good is determined by how much demand for the product changes
as the price increases or decreases. An inelastic product is one that
consumers continue to purchase even after a change in price. The
elasticity of a good or service can vary according to the number of close
substitutes available, its relative cost, and the amount of time that has
elapsed since the price change occurred.
 What Is Elasticity?

Companies that operate in fiercely competitive industries provide goods or

services that are elastic because these companies tend to be price-takers
 or those that must accept prevailing prices. When the price of a good or
service reaches the point of elasticity, sellers and buyers quickly adjust
their demand for that good or service. The opposite of elastic is inelastic.
When a good or service is inelastic, sellers and buyers are not as likely to
adjust their demand for a good or service when the price changes.
In economics, elasticity measures the percentage change of one economic
variable in response to a percentage change in another.[1] If the price
elasticity of the demand of something is -2, a 10% increase in price causes
the demand quantity to fall by 20%.
Elasticity is an important economic measure, particularly for the sellers
of goods or services, because it indicates how much of a good or
service buyers consume when the price changes. When a product is
elastic, a change in price quickly results in a change in the 
quantity demanded. When a good is inelastic, there is little change
in the quantity of demand even with the change of the good's price.
The change that is observed for an elastic good is an increase in
demand when the price decreases and a decrease in demand when the
price increases.
Elasticity also communicates important information to consumers. If
the market price of an elastic good decreases, firms are likely to reduce
the number of goods or services they are willing to supply. If the
market price goes up, firms are likely to increase the number of goods
they are willing to sell. This is important for consumers who need a
product and are concerned with potential scarcity.
 Example of elastic goods
Typically, goods that are elastic are either unnecessary goods or
services or those for which competitors offer readily available
substitute goods and services. The airline industry is elastic because it is
a competitive industry. If one airline decides to increase the price of its
fares, consumers can use another airline, and the airline that increased
its fares will see a decrease in the demand for its services. Meanwhile,
gasoline is an example of a relatively inelastic good because many
consumers have no choice but to buy fuel for their vehicles, regardless
of the market price.
• Definition of Elasticity
• In today's economy, doesn't it seem that the less expensive a product,
the more people seem to want it? In economics, elasticity is used to
determine how changes in product demand and supply relate to
changes in consumer income or the producer's price. To calculate this
change, we can use the following formula:
• Elasticity = % Change in Quantity / % Change in Price
“Elasticity of demand is the responsiveness of the quantity demanded
of a commodity to changes in one of the variables on which demand
depends. In other words, it is the percentage change in quantity
demanded divided by the percentage in one of the variables on which
demand depends.”
The four factors that affect price elasticity of demand are
(1) availability of substitutes, (2) if the good is a luxury or a necessity,
(3) the proportion of income spent on the good, and (4) how much
time has elapsed since the time the price changed. If income elasticity
is positive, the good is normal.
The four main types of elasticity of demand are price elasticity of
demand, cross elasticity of demand, income elasticity of demand, and
advertising elasticity of demand.
Types of Elasticity of Demand

Based on the variable that affects the demand, the elasticity of demand
is of the following types. One point to note is that unless otherwise
mentioned, whenever the elasticity of demand is mentioned, it implies 
price elasticity.
Price Elasticity

The price elasticity of demand is the response of the quantity

demanded to change in the price of a commodity. It is assumed that
the consumer’s income, tastes, and prices of all other goods are steady.
It is measured as a percentage change in the quantity demanded
divided by the percentage change in price. 
Ep=

Change in quantity
------------------------- *100
Original Quantity
---------------------------------------------------
Change in Price
---------------------------------*100
Original Price
Income Elasticity

The income elasticity of demand is the degree of responsiveness of the

quantity demanded to a change in the consumer’s income.
Symbolically,

EI=Percentage change in quantity demanded

---------------------------------------------------------------
Percentage change in income
Cross Elasticity

The cross elasticity of demand of a commodity X for another

commodity Y, is the change in demand of commodity X due to a change
in the price of commodity Y

Cross price elasticity (XED) = (% change in demand of product A) / (%

change of price of product B), where products A and B are different
offerings.
 Concept of Production
• Production in Economics is sometimes defined as the creation of utility or
the creation of wants – satisfying goods’ and services. It is said that just as
a man cannot destroy matter, he also cannot create matter.
• If consuming means extracting utilities from,” says Fraser, “producing
means putting utility into.”
• Production, therefore, should be defined, not as a creation of utility, but
the creation (or addition) of value. Utilities are created in three forms:
• Form utility
• Time utility
• Place utility.