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This document outlines the theory of demand and supply, focusing on the law of demand and factors influencing demand. It covers key concepts such as elasticity, determinants of demand, and the importance of demand forecasting for businesses. Additionally, it discusses how various factors like consumer preferences, income levels, and government policies impact market demand.
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0% found this document useful (0 votes)
50 views46 pagesChapter 3 Demand
This document outlines the theory of demand and supply, focusing on the law of demand and factors influencing demand. It covers key concepts such as elasticity, determinants of demand, and the importance of demand forecasting for businesses. Additionally, it discusses how various factors like consumer preferences, income levels, and government policies impact market demand.
Uploaded by
Umesh JaiswalCopyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
/ 46
THEORY OF DEMAND AND
SUPPLY
UNIT -1: LAW OF DEMAND AND ELASTICITY OF DEMAND
LEARNING OUTCOMES
At the end of this Unit, you will be able to:
¢ Explain the meaning of Demand.
Describe what Determines Demand.
Explain the Law of Demand.
Explain the difference between Movement along the Demand Curve and Shift of
the Demand Curve.
Define and Measure Elasticity.
Apply the Concepts of Price, Cross and Income Elasticities,
Explain the Determinants of Elasticity.
Explain the Importance of Demand Forecasting in Business.
Describe the various Forecasting Techniques.
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© The Institute of Chartered Accountants of India EL 250255 ECONOMICS
CHAPTER OVERVIEW IC?
=) (a we
Consider the following hypothetical situation
‘Aroma Tea Limited is considering diversifying its business. A meeting of the board of directors is called. Wile
discussing the matter, Rajeev Aggarwal, the CEO of Aroma Tea Limited asks, Sanjeev Bhandari, the marketing
head, “What do you think Sanjeev, should we enter info green tea business also?What does the market pulse say?
Who all are therein this market? How wil the demand for green tea affect the demand for our black tea? Is green tea
2 luxury good or is it a necessity now? What are the key determinants of the demand for green tea? Will coffee
drinkers or soft crinkers shift to green tea? The answers to these questions wll help us better understand how to
price and positon our brand in the market. “Before we rush ino this line, | want a report on exactly why you believe
green tea willbe the star of our company in the coming five years?”
‘As an entrepreneur of a frm or as a manager of a company, you would often face situations in which you have to
‘answer questions similar to the above. Why do prices change when events such as weather changes, wars,
pandemics of new discoveries occur? Why i it that some producers are able to charge higher prices than others?
‘The answers to these and a thousand other questions can be found in the theory of demand and supply.
‘The market system is governed by market mechanism. Demand and supply are the forces that make market
‘economies work. These two together determine the price and quantiy sold of a commodity or service. While buyers
constitute the demand side ofthe marke, sellers make the supply side ofthat market. Since business firms produce
‘goods and services to be sold in the market, i is important for them to know how much oftheir products would be
Wanted by buyers during a given period of time. The buyers include consumers, businesses and even government.
‘The quent that the buyers buy ata given price determines the sizeof the market. As we are aware, as far as a fm
is concerned, the size of the market isa significant determinant of its prospects.
When a market is compelitve, ts behaviour is suitably described by the demand and supply model. We understand
that the terms demand and supply refer to the behaviour of buyers and sellers respectively as they interact each
© The Institute of Chartered Accountants of India other in markets. A thorough understanding ofthe demand and supply theory is therefore essential fr any business
firm, We shall study the theory of demand inthis Unit. The theory of supply wil be discussed in Unit.
1.0 MEANING OF DEMAND
The term ‘demand! refers tothe quantity of a good or service that buyers are wing and able to purchase at various
prices during a given period of time. Its tobe noted that demand, in Economics, is something more than the desire
to purchase, though desie is one element oft. For example, people may desire much bigger houses, luxurious cars
etc. But there are also constraints that they face such as pres of products and limited means to pay. Thus, wants or
desires together with the real world constraints determine what they buy. The effective demand for a thing depends
‘on (}) desire (i) means to purchase and (ji) wilingness to use those means for that purchase. Unless desite is
backed by purchasing power or abit to pay and wilingness to pay, it does not constitute demand, Effective demand
alone would figure in economic analysis and business decision.
‘Two things are to be noted about the quantiy demanded.
(i) The quentty demanded is always expressed at a given price. At different prices diferent quantities of a
commodity are generally demanded,
(i) The quantity demanded is @ flow. We are concemed not with a single isolated purchase, but with a
continuous fow of purchases and we must therefore express demand as ‘so much per period of time’ i,
cone thousand dozens of oranges per day, seven thousand dozens of oranges per week and S0 on.
In short ‘By demand, we mean the various quanttes of a given commodity or service which consumers would buy in
‘one market during a given period of tine, at various prices, or at various incomes, or at various prices of related
goods’.
(1.1 WHAT DETERMINES DEMAND?
Knowledge ofthe common determinants of demand for a product or service and the nature of relationship between
demand and its determinants are essential for a business fim for estimating the market demand for its products.
There are a number of factors which influence the demand for a commodity. All these factors are not equally
important. Moreover, some of these factors cannot be easily measured or quantified. The important factors that
determine demand are given below.
() Price of the commodity: Obviously, the good's own price is a key determinant ofits demand. Ceteris
paribus ie. other things being equal, the demand for a commodity is inversely related to its price. implies
that a rise in the price of a commodity brings about a fall in the quantty purchased and vice-versa, This
happens because of income and substitution effects.
(ii) Price of related commodities: Related commodities are of two types: ()) complementary goods and (i)
‘competing goods or substitutes.
Complementary goods and services are those that are bought or consumed together or simultaneously
Examples are: fea and sugar, automobile and petrol and pen and ink. The increase in the demand for one
causes an increase inthe demand forthe other. When two commodities are complements, a fallin the price
of one (other things being equal) will cause the demand forthe other to rise. For example, a fll in the price
of petrokdriven cars would lead to a rise in the demand for petrol. Similarly, computers and computer
© The Institute of Chartered Accountants of India BE 250255 ECONOMICS
(iy
software are complementary goods. A fallin the price of computers will cause a rise in the demand for
software, The reverse willbe the case when the price of a complement rises. An increase inthe price of a
complementary good reduces the demand forthe good in question. Thus, we find that, there isan inverse
relation between the demand for a good and the price ofits complement.
Two commodities are called competing goods or substitutes when they satisfy the same want and can be
Used with ease in place of one another. For example, tea and coffee ink pen and ball pen, different brands
of toothpaste ele. ae substitutes for each other and can be used in place of one another easily. When
goods are substitutes, if the price of @ product being purchased goes up, buyers may switch to a cheaper
substitute, This decreases the demand for the product ata given price, but increases the demand forthe
substitute. Similarly, a fll inthe price ofa product (eters paribus) leads toa fll inthe quantity demanded
of ts substitutes. For example, ifthe pice of tea falls, people will ty to substitute i for coffee and demand
more of t and less of coffee ie. the demand for tea wil ise and that of coffee wil fall. Therefore, there is
director positive relation between the demand fora product and the price of is substitutes.
Disposable Income of the consumer: The purchasing power of a buyer is determined by the level of his
Aisposeble income. Other things being equal, the demand for @ commodity depends upon the disposable
income ofthe potential purchasers. In general, inorease in disposable income tends to increase the demand
for particular types of goods and services at ary given pice. A decrease in csposable income generally
lowers the quantity demanded at all possible prices.
The nature of relationship between disposable income and quantity demanded depends upon the nature of
goods. A basic description of the nature of goods is useful n describing the effect of income on demand.
Normal goods are those that are demanded in increasing quantities 2s consumers’ income increases. Most
goods and services fall under the category of normal goods. Household furniture, clothing, automobiles,
consumer durables and semi durables etc. alin this category. When income is reduced (for example due
to recession), demand for normal goods falls.
There are some commodities for which the quantity demanded rises only up to a certain level of income and
decreases with an increase in money income beyond this level These goods are called inferior goods.
Essential consumer goods such as food grains, fuel, cooking ol, necessary clothing etc, satisfy the basic
necessities of life and are consumed by all individuals in a society. A change in consumers’ income,
although will cause an increase in demand for these necessities, but this increase will be less than
proportionate tothe increase in income. This is because as people become richer, there isa relative decline
in the importance of food and other non durable goods in the overall consumption basket and a ris inthe
importance of durable goods such as a TV, car, house etc. Demand for luxury goods and prestige goods
arise beyond a certain level of consumers’ income and keep rising as income increases.
Business managers should be fully aware of the nature of goods which they produce (or the nature of need
‘wich their products satisfy) and the nature of relationship of quantities demanded with changes in buyers!
incomes. For assessing the current as well as future demand for ther products, they should also recognize
the movements in the macro economic variables that affect buyers incomes.
Tastes and preferences of buyers: The demand for 2 commodity also depends upon the tastes and
preferences of buyers and changes in them over a period of time. Goods which are modern or more in
fashion command higher demand than goods which are of old design or are out of fashion. Consumers may
Perceive a product as obsolete and discard it before i is ful utilised and then prefer another good which is
© The Institute of Chartered Accountants of India ™
currently in fashion. For example, thee is greater demand forthe latest digital devices and trendy clothing
‘and we find that more and more people are discarding these goods curently in use even though they could
have used i for some more years.
Enteral efects on utity such as' demonstration effect’ bandwagon effect, Veblen effect and ‘snob effect”
do play important roles in determining the demand for a product. Demonstration effec, aterm coined by
James Duesenbery, refers to the desire of people fo emulate the consumption behaviour of others. In
ther words, people buy or have things because they see that other people are able to have them. For
‘example, an individuals demand for cell phone may be affected by his seeing a new model of cell phone in
his neighbour or rend’s house, either because he Ikes what he sees or because he iqures out that i his
neighbour or friend can have it, he too can.
Bandwagon effec refers to the extent to which the demand for a commodity is increased due tothe fact that
others ate also consuming the same commodity, it represents the desire of people to purchase a
commodity in oder tobe fashionable or sys orto conform to the people they wish to be associated
with,
By ‘snob effect we refer tothe extent to which the demand for a consumers’ good is decreased owing tothe
fact that others are also consuming the same commodity. This represents the desire of people to be
exclusive; tobe diferent; to dissociate themselves from the “common herd.” For example, when a product
becomes common among ll, some people decrease or altogether stop its consumption.
Highly priced goods are consumed by status seeking rch people to saisty their need for conspicuous
consumption, Ths is called ‘Veblen effect’ (named after the American economist Thorstein Veblen).For
example, expensive cars and jewels. The distinction between the snob effect and the Veblen effect is that
the former is a function ofthe consumption of others and the latter is a function of price We conclude that
people have tastes and preferences and these do change - sometimes, due to external and sometimes due
to internal causes - and infuence demand.
Knowledge regarding tastes and preferences is extremely valuable forthe manufacturers and marketers as
itwould help them appropriately design new models of products and services and plan production to sui the
changing tastes and needs ofthe customers.
Consumers’ Expectations
Consumers’ expectations regarding future prices, income, supply conditions etc influence curent demand,
If the consumers expect increase in future prices, increase in income and shortages in supply, more
quantities will be demanded. If they expecta fll in price or fll in income they wil postpone ther purchases
of nonessential commodities and therefore, the current demand for them wil fll Levels of consumer and
business confidence about ther future economic situations also affect spending and demand.
Other factors: Apart from the above factors, the demand for @ commodity depends upon the folowing
factors:
(2) Size of population: Generally larger the size of population of a counity o @ region larger would
be the number of buyers and the quantity demanded in the market would be higher at every price.
‘The opposite isthe case when population is ess.
(&) Age Distribution of population: Ifa larger proportion of people belong to older age groups
relative to younger age groups, there will be increased demand for geratc care services,
© The Institute of Chartered Accountants of India EL 251255 ECONOMICS
()
@
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spectacles, walking sticks, etc and less demand for children’s books. Similarly, if the population
Consists of more of children, demand for toys, baby foods, toffees, etc will be more, Likewise, if
there is migration from rural areas to urban areas, there will be decrease in demand for goods and
‘services in rural areas,
The level of National Income and its Distribution: The level of national income is @ crucial
determinant of market demand. Higher the national income, higher will be the demand for all
‘normal goods and services. The wealth of a country may be unevenly distributed so that there are
a few very rch people while the majority is very poor. Under such conditions, the propensity to
‘consume of the country wll be relatively less, because the propensity to consume of the rich
‘people is ess than that ofthe poor people. Consequently, the demand for consumer goods wil be
‘comparatively less. If the distribution of income is more equal, then the propensity to consume of
the country as a whole will be relatively high indicating higher demand for goods.
Consumer-credt facility and interest rates: Availabilty of credit facies induces people to
purchase more than what their current incomes permit them. Credit facies mostly determine the
‘demand for investment and for durable goods which are expensive and require bulk payments at
the time of purchase. Low rates of interest encourage people to borrow and therefore demand wil
be more,
Government policies and regulations; The governments infuence demand through its taxation,
purchases, expenditure, and subsidy polices, While taxes increase prices and decrease the
‘quantity demanded, subsidies decrease the prices and increase the quantity demanded. For
‘example taxes on luxurious goods and subsidies for solar panels. Similar total bans, retitons
‘and higher taxes may be used by government to restrict the demand for socially undesirable goods
and services. Governments policy on intemational rade also wil affect the domestic demand for
‘goods and serves.
‘Apart from above, factors such as weather conditions, business conditions, stage of business
‘yd, weatt, levels of education, marital status, socioeconomic class, group membership, habits
of the consumer, social customs and conventions, salesmanship and advertisements also play
important roles in inuencing demand,
THE DEMAND FUNCTION
‘AS we know, a function is @ symbolic statement of a relationship between the dependent and the independent
variables.
‘The demand function states in equation form, the relationship between the demand for a product (the dependent
variable) and its determinants (the independent or explanatory variables) Any other factors that are not explicily
listed in the demand function are assumed to be irelevant or held constant. A simple demand function may be
expressed as follows:
Where Q,
Px
Qu=f(Px¥,Pa)
isthe quantity demanded of product X
isthe price of the commodity
© The Institute of Chartered Accountants of India Y isthe money income of the consumer, and
P, is the price of related goods
‘The demand function stated as above does not inicate the exact quantitative relationship between Q, and Px, M end
P,.. For this, we need to write the demand function in a particular form with specified values ofthe explanatory
variables appearing on the rght-nand side. For example; we may write Cx = 45 + 2y+ 1, ~2P. In this unit, we
willbe studying demand as a function of only price, Keeping everyting else constant
(@® 1.3 THE LAW OF DEMAND
Most of us have an implicit understanding of the law of demand. The law of demand is one ofthe most important
laws of economic theory. The law states the nature of relationship between the quantity demanded ofa product end
its price, Prof. Alfred Marshall defined the Law thus: “The greater the amount to be sold, the smaller must be
the price at which itis offered in order that it may find purchasers or in other words the amount demanded
increases with a fallin price and diminishes witha rise in price”.
‘The law of demand states that other things being equal, when the price ofa good rises the quantity demanded ofthe
‘good wil fall. Thus, there isan inverse relationship between price and quantity demanded, ceteris parbus. The ‘ther
things’ which are assumed to be equal or constant are the prices of related commodities, income of consumers,
tastes and preferences of consumers, and all factors other than price which influence demand. (Retr section 1.1
above). I these factors which determine demand also undergo a change, then the inverse price-demand relationship
may not hold good. For example, i incomes of consumers increase, then an increase in the price of a commodity,
may not result in a decrease in the quantity demanded of i. Thus, the constancy ofthese ‘other factors’ is an
important assumption ofthe law of demand.
‘The quantity demanded isthe amount ofa good or service that consumers are wiling to buy at a given price, holding
constant all he other factors that infuence purchases. The quantity demanded of a good or service can exceed the
quantity actualy sold
‘The Law of Demand may be ilustrated with the help ofa demand schedule and a demand curve.
1.3.0 The Demand Schedule
‘A demand schedule is a table showing the quantities of a good that buyers would choose to purchase at ifferent
prices, per unit of time, with all other variables held constant, To illustrate the relation between the quantity of a
‘commodity demanded and its price, we may take a hypothetical data for prices and quantities of ice-cream. A
demand schedule is drawn upon the assumption that all the other influences remain unchanged. It thus attempts to
isolate the influence exerted by the price ofthe good upon the amount sold.
Table 1: Demand Schedule of an Individual Buyer
50 2
© The Institute of Chartered Accountants of India EL 250255 ECONOMICS
c 40 4
D 30 6
E 20 8
F 10 10
G 0 2
Table 1 shows how many cups of ice-cream this particular buyer buys each week at diferent prices of ice-cream,
holding constant everything else that influences how much of ice-cream ths particular consumer wants to buy. If ice-
‘reamis fre (price =0), she consumes 12 cups of icecream per week. As the price ries, she buys fewer and fewer
cups of ice-cream. When the price reaches € 60 per cup, she does not buy ice-cream at al. The above table depicts
{an inverse relationship between price and quantity of ice-cream demanded. We may note that thatthe demand
schedule obeys the law of demand: As the price of ice-cream increases, ceteris paribus, the quanty demanded falls,
1.3.1 The Demand Curve
‘A demand curve is @ graphical presentation ofthe demand schedule. By convention, the vertical axis ofthe graph
measures the price per unit of the good. The horizontal axis measures the quantity ofthe good, which is usually
‘expressed in some physical measure per time period. By plotting each pair of values as a point on a graph and
joining the resuiting points, we get the indvidua’s demand curve for a commodity. It shows the relationship between
the quantities ofa good that buyers are wilng to buy and the price ofthe good. We can now plot the data from Table
‘10n a graph.
In Fig. 1, we have shown such graph and plotted the seven points corresponding to each price-quantty
‘combination shown in Table 1. The demand curve hits the vertical axis at price & 60 indicating that no quantity is
demanded when the price is 60 (or higher). The demand curve hits the horizontal quantity axis at 12, the amount
ice-cream that the consumer wants if the price is zero. Point A shows the same information as the frst row of Table
1, and Point G shows the same information as does the last row ofthe table.
or2aas67 00m I x
‘quantity of ce-ream (eups)
Fig.
: Demand Curve for Ice-cream
© The Institute of Chartered Accountants of India We now draw a smooth curve through these points. The curve is called the demand curve for ice-cream and shows
the quantity of ice-cream that the consumer would like to buy at each price, The negative or downward slope
indicates thatthe quantity demanded increases as the price falls. Consumers are usually ready to buy more ifthe
price is lower. Briefly put, more of a good will be purchased at lower prices. Thus, the downward sloping demand
curve is in accordance with the law of demand which, as stated above, describes an inverse price-demand
relationship.
The slope of a demand curve is - APIAQ (i the change along the vertical axis divided by the change along the
horizontal axis). The negative sign of his slope is consistent with the law of demand.
‘The demand curve for a good does not have to be linear ora straight tne it can be cunilinear- meaning its slope
may vary along the curve. the change in quantity demanded does not fallow a constant proportion, then the demand
curve wll be non near. However, near demand curves provide a convenient tool for analysis.
1.3.2. Market Demand Schedule
‘The market demand for a commodity gives the alternative amounts ofthe commodity demanded per ime period, at
various alternative prices, by al the buyers in the market. In other words, it isthe total quant that all the buyers of a
‘commodity are wiling to buy per unit of ime ata given price, other things remaining constant. The market demand
for a commodity thus depends on all the factors that determine the indviduats demand and, in addition, on the
number of buyers ofthe commodity in the market.
‘When we add up the various quantities demanded by diferent consumers in the market, we can obtain the market
1) when the percentage change in quantity demanded is greater than the
percentage change in price. In such a case, demand is said to be elastc. [FigureS (dn other words, the quantity
demanded is relatively sensitive to price changes. When drawn, the elastic demand tne is fairy fat.
© The Institute of Chartered Accountants of India EL 250255 ECONOMICS
Elasticity is less than one (Ep < 1) when the percentage change in quantity demanded is ess than the percentage
‘change in price, In such a case, demand is said to be inelastic{Figure 8 (e)]In this situation, when price falls the
buyers are unable or unwiling to significantly contract demand, In other words, the quantity demanded is relatively
insensitive to pre changes, When drawn, the inelastic demand line is fairy steep.
Elasticity is infinite, (Ep= °°) when a ‘small price reduction raises the demand from zero to infty. The demand
curve is horizontal atthe price level (where the demand curve touches the vertical axis) As long asthe price stays at
‘one particular level any quantity might be demanded. Moving back and forth along tis line, we find that there is
change in the quantity demanded but no change inthe price. If there is a slight increase in price, they would not buy
anything from the particular seller. That is, even the smallest price rise would cause quantity demanded to fall to
zero. Roughly speaking, when you divide a number by zero, you get infty, denoted by the symbol=>. So a
horizontal demand curve implies an infrite price elasticity of demand. This type of demand curve is found in a
perfectly competitive market. The horizontal demand curve in figure 8 (c) represents perfectly or infntely elastic
demand,
vy ne Da YP = @
°
g g Ps
i z
.
x x
° ‘Quantity, ‘Quantity Quantity
Fig. S(@) Fig 8(b) Fig. 8(¢)
Demandcurve of zero —_Demandcuve of untary Demand curve of
hati elasticity Inne elasticity
YY wt yh Dect
°
BI 4
3
ao Eos
x >
o_o oT x
ara ‘Quantity
Fig ay =
Demand curve of elasticity ee
Demand curve of Elasticity less than ene
createrthan one
© The Institute of Chartered Accountants of India Table 4 : Elasticity Measures, Meaning and Nomenclature
Zero ‘Quanity demanded does not change as pice | Perfecly (or completely)
changes inelastic.
Greater than zero, but less | Quantity demanded changes by a smaller | Inelastic
than one percentage than does price
One ‘Quantity demanded changes by exactly the | Unit elasticity
same percentage as does price
Greater than one, but less | Quantity demanded changes by a larger | Elastic
than infinity percentage than does price
Infinity Purchasers are prepared to buy all they can | Perfectly (or infinitely elastic
‘obtain at some price and none at all at an
even slightly higher price
Now that we are able to classify goods according to their price elasticity, let us see whether the goods mentioned
below are price elastic or inelastic
1 Headphones 100-150, 500+400 _ | 5, Elastic
¥00+150 500-400
2. Wheat 500=520, 20518 _ 57 24 Inelastic
500520 20-18
3 ‘Common Salt 1000-1005 , 947.50 _ Z Inelastic
4000-1005 “97.50 ~°2748<1
‘What do we note in the above hypothetical example? We note thatthe demand for headphones is quite elastic, while
«demand for wheat is quite inelastic and the demand for saltis almost the same even after a reduction in price.
‘The price elasticity of demand forthe vast majority of goods is somewhere between the two extreme cases of zero
‘and infty. Generally, in real world situations also, we find thatthe demand for goods like refgerators, TVs, laptops,
fans, etc. is elastic; the demand for goods like wheat and rice is inelastic; and the demand for salt is highly inelastic
‘or perfectly inelastic, Why do we find such a difference in the behaviour of consumers in respect of diferent
commodities? We shall explain later at length those factors which are responsible forthe differences in elasticity of
demand for various goods. Before that, we will consider another method of calculating price-elasticty which is called
total outlay method.
© The Institute of Chartered Accountants of India EL 2 s1v