UNIT # 3: Law of demand

This law expresses the relationship between quantity of a commodity

demanded and price. The law states that demand varies inversely with price,
not necessarily proportionately.
The law can also be stated as: a rise in the price of a commodity or
service is followed by a reduction in demand and a fall in price is followed by
an increase in demand, if conditions of demand remain constant.
In Marshalls words: the greater the amount to be sold, the smaller must
be the price at which it is offered in order that it may find purchasers, or in
other words the amount demanded increases with a fall in price and diminishes
with a rise in price.
Therefore demand is a function of price.
Limitations of the law
There are certain exceptions to the law of demand i.e. demand does not
contract when price rises and vice versa.
1) Change in taste or fashion: If the fashion is changed, even the
commodity price falls no one will be willing to purchase.
) Change in income: If the consumer!s income is increased, he will be
willing to buy more even the prices are high.
") Change in other prices: The law of demand says that consumer
purchase more when the price falls. #onsider the price of tea falls and at
the same time the price of coffee also falls even more heavily. $o
consumers would li%e to go for more coffee rather than tea. &hich is a
contradiction to the law of demand
') Discover of s!"stit!tes: $ubstitute goods are those goods, which
satisfy the same need. If there are substitute goods ( and ) then demand
of commodity ( may rise if the price of commodity ) is increased.
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Ca!ses of changes in demand
Demand can be afected by the following factors.
1) Changes in tastes, preferences and fashion.
2) Climate or weather change.
3) Change in the size and composition of population.
) Changes in money supply.
!) Change in the price of a commodity.
") Change in the real income.
#) Change in the le$el and distribution of income. %&a' from
rich to poor)
() Change in sa$ings. %)ore sa$ings less demand)
*) Change in asset preferences. %Consumer prefer cash than
goods)
1+) Conditions of trade. %,oom and depression of
economy)
11) -'pectations or anticipations. %if people are e'pecting
change in income or prices of the commodities, they will
wait for the change to occur for ma.ing purchases.)
12) /rices of related goods.
0ubstitute goods. %&ea or cofee)
Complementary goods. %,read and 1am, car and fuel)
2oint supply. %3heat and straw)
Composite supply. %4f fuel is cheap, transport is
cheap)
13) )ar.et size
1) 5d$ertising or mar.eting efort
#hortcoming of the !tilit analsis
)odern economists are not satis6ed with the utility analysis
on the grounds of both theory and operational e7ciency.
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8ollowing are the defects pointed out towards )arshallian
approach to the demand theory.
Unsound Psychology: )ar.et demand is an ob1ecti$e
phenomenon. ,ut the utility theorist has e'plained it on
the bases of desire, moti$ation etc. &o attribute moti$es
to the consumer is unrealistic.
Cardinal measurements not possible: Cardinal
measurements means utility can be measured in terms
of de6nite numbers, which is not possible. 3e can only
ha$e ordinal measures i.e. we can only compare two
situations to 1udge satisfaction le$els.
Wrong assumption of independent utilities:
9tilities are not independent. 9tilities of substitute
goods and complementary goods do afect each other:s
demand.
Income efect: 3hen the prices of commodities go
down, real income of a consumer increases. &his efect
is totally ignored.
Substitution efect: 3hen income increases
consumers substitute cheap goods with e'pensi$e
one:s. &his efect is also badly ignored.
Hicks says, ;the distinction between direct and
indirect efects of a price change is accordingly left by
the cardinal theory as an empty bo' which is crying out
to be 6lled.<
Assumption of constant marginal utility of money
is rong: 0ince the utility is measured in money, and
the measures cannot be change. ,ut as the consumer
is purchasing the marginal utility should increase. &his
efect is totally ignored.
Applies to one commodity orld: 4n multi product
world the marginal utility of money cannot be constant.
/roducts with the diferent prices will bring diferent
change in the marginal utility. 4f marginal utility of
money will change the law will not hold any more.
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Assume too much and e!plain too little: &here are
so many assumptions but the theory does not e$en
answer some of the fundamental =uestions as well.
Shifts in the Demand Curve
Suppose there is an increase in disposable income which increases
the quantity demanded.
This effect can be shown in Fig, where the price remains constant at
Op but the increase in income has shifted the curve from DD to D1D1
So the quantity demanded at Op rises from q to q1. fall in income or
a decline in taste for e!ample would produce the reverse result, i.e. a
shift from D1D1 to DD.

"#AS$ICI$% &' (")A*(

>aw of demand shows an in$erse relationship between
demand and price, i.e. if price increases, demand increases
and $ice $ersa.
Change in demand, due to the price change is .nown as
-lasticity of Demand.
4t is the rate at which the =uantity demanded $aries with a
change in price.
4t is the degree of relationship between demand and price.
"#AS$IC A*( I*"#AS$IC (")A*(:
!
5 change in demand is ne$er proportional to the change in
price.
4f a small change in price leads to a great change in
demand, then demand is elastic or sensiti$e or responsi$e.
4f a big change in price lead to a small change in demand,
then it is inelastic or non?responsi$e demand.
8or e'ample, @eduction in price of gold A -lastic demand
@eduction in price of salt A 4nelastic demand
Demand is elastic, when price decreases. &otal re$enue
increases. %/rice B Cuantity)
Demand is inelastic, when price decreases. &otal re$enue
decreases. %/rice B Cuantity)
)arshall says< &he elasticity or responsi$eness of demand in
a mar.et is great or small according to the amount
demanded increases much or little for a gi$en fall in price
and diminishes much or little for a gi$en rise in price<.
-lasticity is a matter of degree only.
CAS"S &' "#AS$ICI$%:
&here are 6$e cases of elasticity.
+, I*'I*I$" "#AS$ICI$% &- P"-'"C$ "#AS$ICI$%:
5 $ery small reduction in price brings unlimited e'tension
of demand.
"

., P"-'"C$#% I*"#AS$IC &- /"-& "#AS$ICI$%D
5ny amount of reduction in price brings no change in the
amount of demand.
0, -"#A$I1"#% "#AS$IC: %>ess elastic demand or commonly
inelastic)
/rice fall is more than increased demand.
#
5rea of the rectangle denotes the total re$enue recei$ed by
the seller.
E)/F A before price change
E):/:F: A after price change
2, -"#A$I1"#% I*"#AS$IC:
/rice fall is less than amount demanded.
E)/F A area before price change, E):/:F: A area after price
change
i.e. E)/F G E):/:F:, &herefore, demand is elastic.
(
3, U*I$ "#AS$ICI$%:
,oth areas are same i.e. E)/F H E):/:F:.
&he price change brings the e'act increase in =uantity. 0o,
total re$enue before and after changing price becomes e=ual.
8or e'ample,
1+ B !+ H !++ %/BC)
! B 1++ H !++ %price changed)
*
$%P"S &' "#AS$ICI$%:
&here are three types of elasticityD
+, P-IC" "#AS$ICI$%:
H I Change in =uantity demanded
I Change in price
'AC$&-" ("$"-)I*I*4 P-IC" "#AS$ICI$% &' (")A*(:
-lasticity is relati$e. 8or one person or at one place, demand
maybe elastic and for another person and place, demand
maybe inelastic.
8ollowing factors determine the price elasticity of demand.
i, *"C"SSA-I"S A*( C&*1"*$I&*A# *"C"SSA-I"S:
,asic necessities of life, we buy 6'ed =uantity,
whate$er is the price. -.g. wheat, rice, consumer goods
etc.
4n poor countries demand for these goods is also
elastic.
E$erall demand for wheat maybe inelastic but in a
speci6c mar.et it could be elastic. 4.e. a small rice in
price, company may lose the entire mar.et.
Demand for lu'uries is elastic. ,ut for rich people
maybe it is inelastic.
>u'urious goods are con$entional necessaries for rich
people.
5 high priced lu'ury for a poor man is a low priced
necessary for the rich.
5 commodity maybe lu'ury in one country and maybe
necessary in another. -.g. 5JC in 95- and /a.istan.
>u'uries of yesterday ha$e become necessaries of
today.
1+
ii, P-&P&-$I&* &' $&$A# "5P"*(I$U-":
( consumer good *e.g. soap) absorb a small proportion of total
expenditure. $o the demand will be inelastic.
iii, 4&&(S HA1I*4 S"1"-A# US"S:
$uch goods demand is always elastic. +.g. wheat, if it is very cheap it
can be used for cattle feed. If expensive.
,ence the demand will be elastic. (nother e.g. coal, used for coo%ing,
heating and industrial purposes. If it becomes expensive, it will be used
to satisfy the most urgent wants. ,ence the demand will remain elastic.
i6, C&)P#")"*$A-% 4&&(S:
If the price of the oil become higher and the cars become cheap. $till the
demand will not increase, i.e. demand is less elastic.
6, (U-A7#" 4&&(S:
-uring war people postponed their purchases e.g. building a house,
buying furniture or having a number of warm suits.
0o demand for such products is elastic, because we
purchase these goods when they are cheap.
6i, #"1"#S &' P-IC"S:
( very expensive or very cheap good, demand will be inelastic. .or e.g.
actual price /0, selling /10, reduced price /20, still people will not
purchase.
5lso, $ery low price, people ha$e already purchased a lot.
0o, demand will be inelastic.
6ii, #"1"# &' I*C&)":
3oor people are more sensitive to price change, whereas a rich man do
not bother much of price change and %eep on purchasing at every price.
&herefore, demand for the poor is more elastic than on
the part of the rich.
6iii, )A-8"$ I)P"-'"C$I&*S:
3eople are ignorant about price fall. $o, demand will be inelastic.
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$% INC&M' 'L(#TICIT):
4esponsiveness of potential buyers to change in income
It shows how the demand changes when the income of the purchaser
changes, the price of the commodity remaining the same.
Income elasticity: 3roportionate change in the quantity purchased
3roportionate change in income
3rice is constant.
It is 5ero income elasticity of demand when change in income ma%es no
change in purchases.
It is negative when increase in income brings less purchase for consumer.
It is positive when income increases and consumer purchases also increases.
3% C*&## 'L(#TICIT):
#hange in the demand of one good causes a change in the demand of
another good.
#ross elasticity of demand for 6 and 7

3roportionate change in purchase of commodity 6
3roportionate change in price of commodity 7
#ross elasticity arises in the case of inter8related goods. .or e.g. substitutes
and complementary goods.
If 6 and 7 are complementary: then, if price of 6 increases, demand of 7
decreases. 9r .if price of 6 decreases, demand of 7 increases.
#ross elasticity of complementary goods is positive.
If 6 and 7 are substitutes: then, reduction in the price of 6, decrease
the demand for 7. (nd. Increase in the price of 6, increase the demand for 7.
#ross elasticity of substitute goods is negative.
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(++LIC(TI&N# &, 'L(#TICIT) &, D'M(ND:
-%T(.(TI&N:
:overnment put taxes on commodities with inelastic demand, i.e. price will
be increased and demand will remain same *consumer goods).
)ut on humanitarian grounds, such taxes are generally avoided.
$% M&N&+&L) +*IC':
If demand is inelastic, monopolist will charge high price and sell a small
quantity.
If demand is elastic, monopolist will lower the price, stimulate the demand
and thus will maximi5e the net revenue.
3% /&INT +*&DUCT# 0 C&M+L'M'NT(*) 1&&D#:
$eparate costs are not applicable. 3roducers are mostly guided by demand
and its nature. .or example transportation, they charge what people can pay.
2% INC*'(#IN1 *'TU*N#:
&hen an industry is sub;ect to increasing returns, manufacturer lowers the
price to develop the mar%et and to ta%e advantage of +conomies of $cale.
3% &UT+UT 4INDI5IDU(L (ND M(*6'T D'M(ND7:
The individual demand is inelastic.
Individuals are not ready to buy the second copy of the newspaper or
maga5ine, whatever is the reduction in price.
<ar%et demand is elastic. )ecause reducing the newspaper or maga5ine
price will result in increased mar%et sale as a whole.
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+lasticity of demand effects industrial output.
8% 9(1'#:
If demand for a specific s%illed labor is relatively inelastic, it is easy to raise
wages, but not otherwise.
:% +overt in plent:
(n increased crop is useless if the demand of the crop is inelastic *not
demanded). It becomes worst if the product is perishable.
.or durable products the demand is less inelastic. In years of bad harvest, the
rise in price would sufficiently compensate the reduced output.
;% 'ffect on the econom:
#onsumer demand sets the guidelines. It affects the total demand of goods
and services in an economy.
3roducers demand different factors of production.
<% 'conomic policies:
:overnment formulates economic policies on the basis of elasticity of
demand.
:overnment can produce goods with inelastic demand and where a
monopoly element is present.
-=% International trade:
+lasticity helps in international trade also.
--% *ate of foreign e>change:
&hile fixing foreign exchange rates, government considers elasticity of
imports and exports.

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THE CLASSIFICATION OF GOODS AND SERVICES
Normal Goods
The vast ma"ority of goods and services in the world are normal
goods.
The demand curve slopes downwards from left to right. For e!ample
lu!ury goods
Inferior Goods
The demand curve for an inferior good also slopes downwards from
left to right.
#t has a negative income elasticity of demand. s incomes increase
the demand curves shifts inwards to the left, indicating that less is
demanded at each price and vice a versa.
Giffen Goods
$iffen goods %named after Sir &obert $iffen' are a special case of
inferior goods.
#n practice $iffen goods are rare. (!amples are the types of food
items that form an important part of the daily diet for e!ample,
bananas or rice, are the main daily foods for many of the world)s most
impoverished people.
The demand curve for $iffen goods slopes upwards from left to right,
unli*e the demand curve for normal goods.
The negative real income effect associated with the rise in price
outweighs the desire to buy less because of the higher price.
Strictly the term +$iffen+ applies only when the +inferior+ income effect
created by a change in price is more powerful than the normal price
substitution effect which leads people to switch their e!penditure in
favour of goods as they become relatively cheaper.
Luxury Gds
,u!ury goods are usually high-priced goods, often with a well-*nown
brand name.
#n contrast to $iffen goods, the income elasticity for lu!ury goods is
positive, as it is for normal goods.
Bads
+.ads+ are simply those things that we would rather not have but
which may e!ist, and be consumed in the sense that people have no
choice but e!perience them.
1!
For e!amples atmospheric pollution, water pollution, noise and crime.
Substitutes
n increase in the price of one product will lead to an increase in the
demand for the other and vice a versa.
For e!ample, a decrease in the price of digital cameras will lead to a
decrease in the demand for traditional film-based cameras.
Cm!"ements
n increase in the price of one will lead to a decrease in the demand
for the other.
For e!ample, a large increase in the price of cars will lead to a
decrease in the demand for petrol.
REVEN#E AND REVEN#E CHANGE
Total Revenue
#n general revenue refers to the money received from the sales of a
product. For this reason, the term +sales revenue+ is often used.
1"
#f all belts can be sold at /0 each, total revenue continues to increase
at a constant rate. Suppose # find that total revenue rises if # reduce
the prices as follow1
This effect can be shown in the form of a simple graph
1#
Avera$e Revenue
2e are going to use the term +average+ in its most common sense1
the average revenue is the total revenue divided by the quantity of
goods sold.
#f all goods are sold at the same price in the given time period 3 as,
say, with our leather belts 3 then the average revenue is the same as
the price. The average revenue curve for the belts is shown in Figure.
Avera$e revenue %urve fr &e"ts
1(
'ar$ina" Revenue
The change in total revenue brought about by a small or unit change
in the quantity flow of sales is *nown as the marginal revenue.
4arginal revenue is not always the same as the price or average
revenue. % (!ample of the leather belts'
Num&er f TV sets
s"d !er (ee)
*ri%e !er set

Tta" revenue

'ar$ina" revenue

+ ,-- ,--
. /0/ ++/- //-
1*
1 //- +,/- /--
2 /./ .+-- 2/-
/ /-- ./-- 2--
, 20/ .3/- 1/-
0 2/- 1+/- 1--
3 2./ 12-- ./-
4 2-- 1,-- .--
+- 10/ 10/- +/-
++ 1/- 13/- +--
+. 1./ 14-- /-
+1 1-- 14-- -
+2 .0/ 13/- 5/-
Chan$e in mar$ina" revenue (hen !ri%e is redu%ed
2+
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lthough Figure does not continue the average curve until it meets
the quantity a!is, we can deduce where it would meet if continued in
the same straight line. #t would meet the quantity a!is at 50 T6 sets 3
twice the marginal revenue quantity when marginal revenue equals
7ero, thus indicating that this supplier would be able to dispose of
only 50 sets, even if he did not charge any price at all %i.e. give them
away'.
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