Unit:-2

By:-Manoj Kumar Gautam

Theory of Demand

In economics, demand has a specific meaning
distinct from its ordinary usage. In common
language we treat demand and desire as
synonymously. This is incongruent from its use
in economics. In economics, demand refers to
effective demand which implies Four things:
Desire for a commodity
Sufficient money to purchase the commodity,
rather the ability to pay
Willingness to spend money to acquire that
commodity
Availability of the commodity



Demand: It is the mother of production.
It implies a desire for the commodity backed
by the ability & willingness to pay for it.
"The demand for a commodity at a given
price is the amount of it which will be
bought per unit of time at that price.

Demand Schedule

The law of demand can be illustrated through
a demand schedule. A demand schedule is a
series of quantities, which consumers would
like to buy per unit of time at different prices.


Demand Schedule for Tea
Demand Curve

The law of demand can also be presented
through a curve called demand curve.
Demand curve is a locus of points
showing various alterative price-quantity
combinations.

Demand Curve


Law of Demand: The demand
for a commodity increases with a
fall in its price and decreases
with a rise in its price, other
things remaining the same.

Assumptions to the Law of
Demand:

(1) Income level should remain constant,
(2) Tastes of the buyer should not change,
(3) Prices of other goods should remain
constant,
(4) No new substitutes for the commodity,
(5) Price rise in future should not be
expected and
(6) Advertising expenditure should remain
the same.

Market Demand:
The total quantity which all the consumers of a
commodity are willing to buy at a given price
per time unit, other things remaining the same,
is known as market demand for the
commodity.

In other words, the market demand for a
commodity is the sum of individual demands
by all the consumers (or buyers) of the
commodity, per time unit and at a given price,
other factors remaining the same.

Individual demand:

The individual demand means the
quantity of a product that an
individual can buy given its price. It
implies that the individual has the
ability and willingness to pay.
Factors affecting demand:

Change in peoples income: More the people earn the
more they will spend and thus the demand will rise. A
fall in income will see a fall in demand.
Changes in population: An increase in population will
result in a rise in demand and vice versa.
Change in fashion and taste: Commodities or which the
fashion is out are less in demand as compared to
commodities which are in fashion. In the same way,
change in taste of people affects the demand of a
commodity.
Changes in Income Tax: An increase in income tax will
see a fall in demand as people will have less money left
in their pockets to spend whereas a decrease in income
tax will result in increase of demand for products and
services because people now have more disposable
income.
Change in prices of Substitute goods: Substitute
goods or services are those which can replace the
want of another good or service. For example
margarine is a substitute for butter. Thus a rise in
butter prices will see a rise in demand for margarine
and vice versa.
Change in price of Complementary goods:
Complementary goods or services are demanded
along with other goods and services or jointly
demanded with other goods or services. Demand for
cars is affected the change in price of petrol. Same
way, demand for DVD players will rise if the prices of
DVDs fall.
Advertising: A successful advertising campaign may
affect the demand for a product or service.
Climate: Changes in climate affects the demand for
certain goods and services.
Interest rates: A fall in Interest rate will see a rise in
demand for goods and services.

7 essential exceptions to the Law of
Demand
The law of demand does not apply in every case
and situation. The circumstances when the law
of demand becomes ineffective are known as
exceptions of the law. Some of these important
exceptions are as under.
1. Giffen goods: It may be any inferior commodity
much cheaper than its superior substitute,
consumes by poor households.
Some special varieties of inferior goods are
termed as Giffen goods. Cheaper varieties of
this category like bajra, cheaper vegetable like
potato come under this category.
2. Conspicuous Consumption:
This exception to the law of demand is
associated with the doctrine propounded
by Thorsten Veblen. A few goods like
diamonds etc are purchased by the rich
and wealthy sections of the society. The
prices of these goods are so high that
they are beyond the reach of the common
man.
3. Conspicuous necessities:
Certain things become the necessities of
modern life. So we have to purchase them
despite their high price. The demand for T.V.
sets, automobiles and refrigerators etc. has not
gone down in spite of the increase in their price.
These things have become the symbol of status.
So they are purchased despite their rising price.
These can be termed as U sector goods.
4. Ignorance:
A consumers ignorance is another factor
that at times induces him to purchase
more of the commodity at a higher price.
This is especially so when the consumer is
haunted by the phobia that a high-priced
commodity is better in quality than a low-
priced one.
5. Emergencies:
Emergencies like war etc. negate the
operation of the law of demand. At such
times, households behave in an abnormal
way. Households Purchase more of the
commodities even when their prices are
going up.
6. Future changes in prices:
Households also act speculators. When
the prices are rising households tend to
purchase large quantities of the
commodity out of the apprehension that
prices may still go up. When prices are
expected to fall further, they wait to buy
goods in future at still lower prices. So
quantity demanded falls when prices are
falling.
7. Change in fashion:
A change in fashion and tastes affects the
market for a commodity. When a broad toe
shoe replaces a narrow toe, no amount of
reduction in the price of the later is
sufficient to clear the stocks. Broad toe on
the other hand, will have more customers
even though its price may be going up.
The law of demand becomes ineffective.
TYPES OF ELASTICITY OF
DEMAND
PRICE ELASTICITY
INCOME ELASTICITY
CROSS ELASTICITY
ADVERTISEMENT ELASTICITY
PRICE ELASTICITY
Price elasticity measures responsiveness
of potential buyers to changes in price. It is
the ratio of percentage change in quantity
demanded in response to a percentage
change in price.
Price Elasticity =
%change in amount demanded
------------------------------------
%change in price
Types of Price Elasticity Of Demand
(Degrees of elasticity of Demand)
Unitary Elastic Demand(ep=1)-
Rectangular Hyperbola
Relatively Elastic Demand(ep>1)-Semi
horizontal shape or flat
Relatively inelastic demand(ep<1)- Semi
variable
Perfectly Elastic Demand(ep=Infinite)-
Horizontal
Perfectly Inelastic Demand(ep=0)- Vertical
INCOME ELASTICITY
Income Elasticity is a measure of
responsiveness of potential buyers to change in
income.
Income elasticity of demand measures the
relationship between a change in quantity
demanded and a change in income. Income
elasticity of demand measures the degree
responsiveness or reaction of the demand for a
good to a change in the income of the
consumer.
Income Elasticity = %change in the quantity Demanded
-------------------------------------------------
%change in Income
Types of Income elasticity of Demand
Zero income elasticity(Vertical)
Positive income elasticity
1-Unitary income elasticity
2- Less than unity
3- More than unity
Negative Income elasticity(Sloped
downward)
Infinite income elasticity(Horizontal)
CROSS ELASTICITY
Here, a change in the price of one good
causes a change in the demand for
another.
Cross elasticity of Demand for X and Y
= %change in quantity demanded of commodity X
-------------------------------------------------------------
% Proportionate change in the price of commodity Y
Types of cross elasticity of demand
Substitute gooods(Demand curve same as
drawn in income elasticity)
Complementary goods(Demand curve
same as drawn in price elasticity)
Advertisement Elasticity
Advertisement Elasticity of Demand =
%change in the quantity Demanded
-------------------------------------------------
%change in Advertisement Expenditure
What are the various methods of
measuring Elasticity of Demand?
Elasticity of demand is known as price-elasticity of
demand. Because elasticity of demand is the
degree of change in amount demanded of a
commodity in response to a change in price.
Price elasticity of demand can be measured
through these popular methods. These methods
are:
Total Expenditure method or Total Outlay Method
Percentage method or Arithmetic method
Graphic method or point method.
Arc Elasticity Method
1. Percentage method:-
According to this method price elasticity is
estimated by dividing the percentage change in
amount demanded by the percentage change in
price of the commodity. Thus given the
percentage change of both amount demanded
and price we can derive elasticity of demand. If
the percentage charge in amount demanded is
greater that the percentage change in price, the
coefficient thus derived will be greater than one.
If percentage change in amount demanded is
less than percentage change in price, the
elasticity is said to be less than one. But if
percentage change of both amount demanded
and price is same, elasticity of demand is said to
be unit.
2. Total expenditure method
Total expenditure method was formulated
by Alfred Marshall. The elasticity of
demand can be measured on the basis of
change in total expenditure in response to a
change in price.
According to this method-In order to
measure the elasticity of demand it is
essential to know how much & in what
direction the total expenditure has changed
as a result of change in the price of a good
Contd..
ep=1 when due to rise or fall in price of a
good, the total expenditure remains
unchanged.
ep>1 when due to fall in price total
expenditure goes up & due to rise in price
total expenditure goes down.
ep<1 when due to fall in price total
expenditure goes down & due to rise in
price total expenditure goes up.
Price of
Commodity
(Rs)
Qty.
Purchased
(Kg)
Total
Expenditure
Change in
Total
Expenditure
Elasticity of
Demand
2
4
1
4
2
8
8
8
8
Remain
Unchanged
ep=1
2
4
1
4
1
10
8
4
10
TE=Decrease
When Price
Increased
& vice versa
ep>1
2
4
1
3
2
4
6
8
4
TE=Increase
when price
increases
ep<1
3. Graphic method:
Graphic method is otherwise known as
point method or Geometric method. This
method was popularized by method.
According to this method elasticity of
demand is measured on different points on
a straight line demand curve. The price
elasticity of demand at a point on a straight
line is equal to the lower segment of the
demand curve divided by upper segment of
the demand curve.
Arc Elasticity
The concept of point elasticity is relevant where a
change in price and the resulting change in quantity is
infinitesimally small. But where the change in price and
the consequent change in demand are substantial, the
concept of arc elasticity is a more relevant concept.
An arc is a portion or a segment of a demand curve. The
question now is to get at the appropriate formula for arc
elasticity. The percentage formula, (Q/P) (P/Q)
Gives different results depending on whether the price is
raised or lowered. Now, let us look at the market
demand schedule and the market demand curve
IMPORTANCE OF ELASTICITY OF
DEMAND
1. Useful for Business
2. Fixation of Prices
3. Helpful to Finance Minister
4. Fixation of Wages
5. In the Sphere of International Trade
7. Significant for Government Economic
Policies
8. Determination of Price of Public
Utilities.
Distribution of burden of taxes
Estimation of Revenue
Revenue:- In The Words of Dooley The
revenue of a firm is its sale receipt.
A firms revenue is the amount it receives
by selling goods or services in a given
period.
Total Revenue:- it may be defined as the
amount of money that the firm receives
from the sale of total output
TR=Summation of MR or TR=P*Q
Contd..
Marginal Revenue:- Change in total
revenue on account of the sale of one
more unit of commodity
MR=TRn-TRn-1
Average Revenue:-It is the ratio of total
revenue to the quantity sold of the product.
AR=TR/Q=P*Q/Q=P
Demand Forecasting
It is the predictions about future demand of
the product. It is an estimation of future
demand based on an analysis of past
statistical data & various effective
determinants.
Characteristics of Demand forecasting
It can be for a particular product or for the
whole product line.
It can be monetary terms or physical terms
or both
It is for a definite period
It is foundation of business planning
It is an estimate of future sales
It is made on the basis of past data and
present conditions prevailing in the
market.
Characteristics of good demand
forecasting
Accuracy
Simplicity & ease of comprehension
Economy
Reliability
Flexibility
Practicability
Demand Forecasts
The three principles of all forecasting techniques:
Forecasting is always wrong
Every forecast should include an estimate of error
The longer the forecast horizon the worst is the
forecast
Aggregate forecasts are more accurate

Selecting a forecasting technique
What is the purpose of the forecast?
How is it to be used?
What are the dynamics of the system for
which forecast will be made?
How important is the past in estimating the
forecast?
Methods of Forecasting Demand

1. Quantitative methods: numerical and statistical methods
for forecasting demand - more objective.

2. Qualitative Methods: subjective, base on judgements of
managers - subjective and depends on managers
judgement.

Combination of two might be used.
Methods of Forecasting Demand
Quantitative methods:
Trend analysis
Simple and multiple regression
Percentage of sales method
Qualitative Methods:
1- Survey of buyers intention: marketer ask buyers about how
many units that they would like to purchase from ABC companys
products for coming period of time.
Well defined buyers
Limited in number
Advantage: Simple and Easy
Disadvantage: buyers might change their opinions, there is no
enforcement on buyers to buy that much, buyers might over or under
estimate.
Methods of Forecasting Demand
2- Test Marketing: this research method is heavily
preferred when company offers a new product
to the market (innovation).
Before offering product to the market, marketers need to get some
real feedback from market.
Marketer: choose a specific region or a store to test the product in
real market conditions.
Advantage: provide real feedbacks about customers reactions and
make estimates upon that.
Disadvantage: no control over who will purchase our new product.
Rivals might get aware of it and company loose all of its competitive
advantage.
Methods of Forecasting Demand
3- Sales force composite:

Marketers have sales managers or representatives at
different sales territories (districts/region) and marketers
believe that sales managers know their territory better than
anybody else.

Marketers ask respective sales manager to forecast
expected sales in their own territories. The total of all these
estimates basically gives companys sales/demand forecast
for next period.
Methods of Forecasting Demand
Advantage: simple
Disadvantage:
forecasting requires especial education and training, most
managers have lack of education on this issue
sometimes managers 1- Over estimate:
More than sales potential
Over production (extra cost)
Additional cost for keeping stock.
2- Under estimate:
Less than sales potential
Demand do not match
Shift to competitors and decrease in sales and decrease
in profitability.

Methods of Forecasting Demand
4- Executive method (jury of executive
method): Company forms a committee to make forecast from
members from different departments (marketing, accounting, R&D,
production)
Make their own forecast and send to committee at a written form
Committee members came together and discuss forecasts and agree
one of the estimates or come up with a new estimate for whole
company.
Advantage: easy and simple to use.
Disadvantage:
estimates are for whole markets and difficult to separate them to
specific market or product line;
Reliability and accuracy of estimate depend on how to up-to-date;
Members can easily influence each other (objectivity is in question).

Methods of Forecasting Demand
5- Delphi method:
Very similar to jury of executives method but this time members are both
inside and outside the company
Members do not know each other and never come together. A moderator
from company organize all the contacts
Moderator prepare data and send it to members to make their own
estimate
Members send their estimate to moderator as a written form and moderator
makes analysis on estimates and form a new data set and conditions and
send back to members for further estimate
This will continue until all members agree on same forecast. (it is suitable
for long-term forecasts).
Advantage: No group pressure, more objective
Disadvantage: Takes long time.
Utility Analysis
utility means satisfaction which a consumer
derive from commodities and services by
purchasing different units of money.
Utility refers to want satisfying power of a
commodity. it may or may not be useful .
It is a subjective concept, it is quite difficult to
measure it directly.
It can be estimated indirectly by the price one
is willing to pay for a specific good.



Utility Analysis
Cardinal
Utility
(Marshall)
Ordinal
Utility
(J.R. Hicks )
Contd..
Cardinal Utility:- This concept of utility
suggests measurement of utility in cardinal
or definite numbers like 1,2 3,4
Ordinal Utility:- This concept of utility
suggests comparision of utility derived
from the consumption of two goods or two
sets of goods. Expression of utility in terms
of numbers is ruled out.

Law of Diminishing marginal Utility (DMU)
Dr. Marshall states this, law as follow: The additional
benefit which a person derives from a given increase of
his stock of anything diminishes with the growth of the
stock that he has another words the law of DMU simply
states that other things being equal, the marginal utility
derived from successive units of a given commodity
goes on decreasing.
Hence the more we have of a thing; the less we want of
it, because every successive unit gives less and less
satisfaction.

The law is explained with the help of
following example
Units of
commodity
No. Of
mangoes
Total Utility
(TU)
Marginal
Utility (MU)
1 8 8
2 14 6
3 16 2
4 16 0
5 14 -2

It will be better to know some terms for
understanding the law and they are.
Initial Utility: It is the utility of the initial or
the first unit. In the table initial utility is 8
Total Utility: In column 3 of the table, it
gives the total utility at each step. For
example if you consume one mango total
utility is 8, if you consume two mangoes,
the total utility is 14.
Zero Utility: When the consumption of a unit of a
commodity makes no addition to the total utility, then it is
the point of zero utility. In our table, the TU after the 3rd
unit is consumed is 16 and the 4th also it is 16. Thus, the
4th mango results in no increase. Thus is the point of
zero utility. It is seen that the total utility is maximum
when the MU is zero.

Marginal Utility: The addition to the total utility by the
consumption of the last unit considered just worthwhile.
The can be worked out by using following formula.

Negative Utility: It the consumption of a unit of a
commodity is carried to excess, then instead of giving
any satisfaction, it may cause dissatisfaction. The utility in
such cases is negative. In the table given above the
marginal utility of the 5th unit is negative.
Assumptions: The assumptions of the law
of DMU are:
All the units of the given commodity are
homogenous i.e. identical in size shape, quality,
quantity etc.
The units of consumption are of reasonable size.
The consumption is normal.
The consumption is continuous. There is no
unduly long time interval between the consumption
of the successive units.
The law assumes that only one type of commodity
is used for consumption at a time.
Though it is psychological concept, the law
assumes that the utility can be measured
cardinally i.e. it can be expressed numerically.
The consumer is rational human being and he
aims at maximum of satisfaction.

Exceptions: The exceptions to the law
of DMU are as follows:
Hobbies: In case of certain hobbies like
stamp collection or old coins, every addition
unit gives more pleasure. MU goes on
increasing with the acquisition of every unit.
Drunkards: It is believes that every does of
liquor Increases the utility of a drunkard.
Reading: reading of more books gives
more knowledge and in turn greater
satisfactions.

INDIFFERENCE CURVE ANALYSIS
This approach to consumer behavior is
based on consumer preferences.

It believes that human satisfaction
being a psychological phenomenon
cannot be measured quantitatively in
monetary terms as was attempted in
Marshall's utility analysis.
In this approach it is felt that it is much
easier and scientifically more sound to
order preferences than to measure
them in terms of money.

The consumer preference approach, is,
therefore an ordinal concept based on
ordering of preferences compared with
Marshall's approach of cardinality.

What are Indifference Curves?
Ordinal analysis of demand (here we will
discuss the one given by Hicks and Allen)
is based on indifference curves. An
indifference curve is a curve which
represents all those combinations of
goods which give same satisfaction to
the consumer.
Assumptions Underlying Indifference
Curve Approach
1 The consumer is rational and
possesses full information about all
the relevant aspects of economic
environment in which he lives.
2. The consumer is capable of ranking
all conceivable combinations of
goods according to the satisfaction
they yield. Thus if he is given
various combinations say A, B, C, D,
E he can rank them as first
preference, second preference and
so on.
3. If a consumer happens to
prefer A to B, he can not tell
quantitatively how much he
prefers A to B.
4. If the consumer prefers
combination A to B, and B to C,
then he must prefer combination
A to C. In other words, he has
consistent consumption pattern
behavior.
5. If combination A has more
commodities than combination B,
then A must be preferred to B.

Table Indifference Schedule
A Consumer's Indifference Curve

Properties of Indifference Curves:
(i) Indifference curves slope
downward to the right
(ii) Indifference curves are
always convex to the origin

Count.
(iii) Indifference curves can never
intersect each other
Count
(iv) A higher indifference curve
represents a higher level of
satisfaction than the lower
indifference curve:
Budget line : A higher
indifference curve shows a higher
level of satisfaction than a
lower one.
Therefore, a consumer in his
attempt to maximize satisfaction
will try to reach
the highest possible indifference
curve.
Consumers Equilibrium: Having
explained indifference curves and
budget line, we are in a position to
explain how a consumer reaches
equilibrium position.
A consumer is in equilibrium when he is
deriving maximum possible satisfaction
from the goods and is in no position to
rearrange his purchases of goods.

We assume that :
(i) The consumer has a given
indifference map which shows his scale
of preferences for various combinations
of two goods X and Y.
(ii) He has a fixed money income which
he has to spend wholly on goods X and
Y.
(iii) Prices of goods X and Y are given
and are fixed for him.