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Theory of Demand

Theory of Demand

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Published by: mukkusrikanthreddy on Dec 16, 2009
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Meaning of Demand Demand means desire/want for something ,but in economics demand refers to effective demand ie; the amount buyers are willing to purchase at a given price over a given period of time. Demand is -: •Demand is desire/want backed by money (Demand=desire+ ability to pay+ will to pay) •Demand is always related to price and time (example :demand for oranges by a household at a price of Rs.50/kg is 5kg oranges /week) •Demand maybe viewed as Ex Ante (intended/potential demand)or Ex Post (amt actual purchased/actual quantity demanded) Definition of demand The demand for a product refers to the amount of it which

Individual demand/Market demand Individual demand :It refers to demand from the individuals /family/household. It is a single consuming entity’s demand. Market demand: It refers to the total demand of all buyers ,taken together. It is the aggregate of the quantities of a product demanded by all the individuals buyers at a given price over a given period of time-it is the sum total of individual demand function Market demand is more important from the business point of view, sales depends on market demand ,so does planning future marketing strategy Prices are determined on the basis of demand for the product etc. The following table shows individual demands for eggs and how the market demand eggs at various prices is derived from it :

Price /doz Rs 10 9 8 7 6 5 4 1 2 3 4 5 6 7






Total dd for eggs 4 7 12 18 23 28 33

3 4 5 6 7 8 9

0 1 3 5 6 7 8

0 0 1 2 3 4 5

0 0 0 1 2 3 4

Determinants of Demand
• • • • Price of the products Income Tastes, Habits, Preferences Relative price of other goods-substitutes and complementary goods Consumers Expectations Advertisement Effect

• • • • • • • • • • Price of the product Distribution of wealth and income in the community Community’s common habits and scale of preferences General standard of living and spending habits of the people Growth of the population Age structure/sex ratio of the population Future Expectations Level of taxation and tax structure Fashions/inventions/innovations/ customs/weather/climate Advertisement/sales propaganda

• •

At any point of time, the quantity of a given product(good/service) that will be purchased by the consumers depends on a number of key variables/determinants. The most important variables are listed below: • The ‘own price’ of the product (P) • The price of the substitute and complementary goods(Ps or Pc) • The level of disposable income(Yd) with the buyers(ie; income left after direct taxes) • Change in the buyers’ taste and preferences(T) • The advertisement effect measured through the level of advertising expenditure(A) • Changes in the population number or number of buyers(N)

Using the symbolic notations, the demand function can expressed as follows: D x =f (Px, Ps, Pc, Yd, T, A, N, u) Where x –commodity Dx - the amount demanded of the commodity Px- price of x u- other unspecified determinants of the demand for commodity x it can also be expressed as Q d= f(P,X1,X2…………..Xn) Where, Qd –quantity demanded P –price X1,X2………..Xn –other determinants of demand

In economics ,a very simple statement of demand function is adopted where all variables, that determine demand are held to be constant ,expect for price. So demand function is denoted as Dx= f(Px) this denotes that demand for commodity x is the function of its price. Demand Equation A linear demand function may be stated as D = a – bP Where, D –amount demanded a - is a constant parameter which signifies initial price irrespective of price b- denotes functional relationship b/w (P) &(D)

b – having a minus sign denotes a negative function, ie; demand for a commodity is a decreasing function of its price. To illustrate a demand equation & the computation of demand schedule assuming estimated demand functions, as Dx = 20 - 2Px, where Dx = Amount demanded for the commodity X Px = Price of X Suppose, the given prices per unit of the commodity X are: Rs.1,2,3,4 and 5 alternatively. In relation to these prices, a demand schedule may be constructed as below Demand schedule for commodity X

Price per unit Rs. (Px) 1 2 3 4 5

Units Demanded (Dx) 18 16 14 12 10

The law of demand expresses the nature of functional relationship b/w two variables of the demand relation viz; the price and the quantity demanded. It simply states that demand varies inversely to change in price. Statement of law of demand Ceteris paribus, the higher the price of a commodity the smaller is the quantity demanded and lower the price ,larger the quantity demanded Other things remaining unchanged ,demand varies inversely with price so, D= f (P)

Price of commodity X (in Rs) 5 4 3 2 1

Quantity demanded (units per week) 100 200 300 400 500

The schedule for commodity X, as price falls demand raises so there is an inverse relationship b/w price and quantity demanded. Assumptions of law of demand The law of demand is based on certain assumptions • No change in consumer’s income • No change in consumer’s preferences

• • • •

No No No No

change in fashion change in the price of related goods expectation of future price changes or shortages change in government policy etc.

Exceptions to the law of demand
The upward sloping curve is contrary to the law of demand, where there is a direct relationship b/w price and demand (as shown in fig-2) These exceptional cases can be listed as • Giffen goods : In the case of certain inferior goods called Giffen goods(named after Sir Robert Giffen), in spite of price rise, demand will also rise. It was seen in Ireland in 19th . Century people were so poor that they spent a major part of income on potatoes and a small part on meat, as price of potatoes, rose the demand also rose since they could not substitute it for meat which was very expensive. Giffen’s paradox is seen the case of inferior goods like potatoes, cheap bread etc. • Speculation : when people speculate about prices on the commodity in the future they may not act according to the laws of demand. Speculating the prices of the commodity will further increase they will demand more of the commodity for hoarding etc. In the stock market, people tend to buy more shares when prices are rising in the hope of bull runs in anticipation of future profits.

Article of snob appeal : Certain commodities are demanded because they happen to be expensive or prestige goods or snob value having a status symbol. So increase in price will lead to increase in demand for such goods. E.g. Diamonds ,exclusive cars etc. Consumer psychological Bias: when a customer is wrongly biased against quality of a commodity a fall in price may not lead to an increase in demand example clearance of stock , discounted sale , etc.

Extension and contraction of demand • A variation in demand implies extension or contraction of demand. A change in demand due to change in price is called extension or contraction of demand. It is a movement along the same demand curve due to changes in price. In the following diagram , demand increases from a to b and then decreases to point c indicating various changes to demand due to price change.

• •

Increase and decrease in demand
Changes in demand are a result of the change in the conditions / factors determining demand other than price. Change in demand thus implies an increase or decrease in demand with price remaining constant. An increase /decrease signifies either more or less will be demanded at a given price. This is represented graphically by movement of the demand curve upwards (in case of increase in demand) and downward movement of demand curve incase of decrease in demand. Reasons for change in Demand:  Changes in income  Changes in taste, habits and preferences  Change in distribution of wealth and population  Change in demand of complimentary / substitute goods  Change in tax structure  Change in value of money  Effect of advertisement and publicity

Network externalities in market demand
It is assumed that individual demands are independent so the market demand function is obtained simply by summing all individual buyers’ demand Individual demand maybe interdependent on the demands of other buyers in the case of some goods, this situation is described as ‘network externalities’. • Bandwagon Effect • Veblen Effect Bandwagon Effect The demand for certain goods are determined not by their usefulness/utility but mostly on account of the bandwagon/ demonstration effect. The demand of individuals is conditioned by the consumption of others in the community (trendsetters/film stars/models/friends/etc)

The figure shows the bandwagon effect and how due to this the demand curve shifts to the right The initial demand curve is DD based on the utility of the product, in this case if there is a price cut to the extent of PP ,due to the price reduction the quantity demanded will increase to QQ in the absence of bandwagon effect. The marketing strategy is to create a bandwagon effect for these goods through the media- advertising, fashion shows, promotional drives etc. It amounts to manipulating the market demand ,to create demand for a product. Examples- Branded jeans, branded shoes, Barbie dolls, new released music CD’s This effect is associated with crazes ,fads and stylishness of people as more people are drawn to use the product due to the demonstration effect.
1 1

Veblen Effect
The snob effect refers to the desire of a person (usually rich people) to own exclusive or unique product – Veblen goods/snob good These goods serve as a status symbol ,so the supplier has to restrict its supply so as to maintain its exclusivity . According to Torstein Veblen the rich class demonstrate their superior of ‘high class’ by spending on prestige goods like diamonds, antiques, rare paintings limited edition cars etc. In this case if the price of the goods increase the snob value increases so demand also increases ,if prices fall the snob value decreases so the demand from the affluent class decreases. A snob good loses its appeal once it is no longer exclusive ,and it becomes a commonly used product. The Veblen effect is of snob appeal is exploited in certain industries like in the airlines industry- the business class fares. In the 5-star hotels the special rates for the suites/deluxe rooms Veblen Effect Paradox

The figure explains the concept of an inherent paradox in the so called snob goods Some goods are initially sold as exclusive goods for the rich strata of society, so its adheres to the Veblen effect ie; at high prices there is a limited ,but high demand from the richer section of the buyers Once these goods are massed produced, their prices fall and they start appealing to the higher middle class groups, while the rich will switch to more exclusive brands. Any further increase in output will lead to further price reduction ,but at this price demand tends to fall on account of the loss of exclusivity. At any point below this price the product will be bought on account of its functional utility So in the case of Veblen Paradox, the demand curve is Z –shaped In the diagram, DD has changing slopes at pt a & b At P1 demand is Q1 when price is lowered to P2 demandQ3 if price is lowered to P3,demand drops to Q2 as brand loses its exclusivity after this point the demand depends on the utility of the product

Types of demand
The demand behavior of the consumer differs with different types of demand in the study of managerial economics it is important to distinguish these types of demand • Demand for consumers’ goods and producers’ goods Goods /services that are demanded by the consumer for direct satisfaction of their wants ie; for consumption purpose- food, clothes, services of doctors ,maids, teachers Goods that demanded by producers in the process of production are called production goods eg; tools and equipment, machinery, raw material, factory building, offices Demand for consumer goods is direct /autonomous ,whereas demand for producer goods is derived ie; based on demand for output Demand for consumer goods is based on marginal utility, whereas the demand for producer goods is based on marginal productivity of the factors of production

Dean (1976) explained this distinctive demand behavior for producer goods in the economy. Buyers of producers goods are professionals /experts, so they are less likely to be influenced by sales promotion. Producer buyers are more sensitive to factor price differences and substitutes. The motive of the producers are purely economic and capital goods are bought on account of profit prospective. The demand of producers goods is derived from consumption demand, so there are frequent fluctuations in demand levels. • Demand for perishable and durable goods: Perishable goods have no durability , they cannot be stored for a long period of time eg. Fish, egg, vegetables etc. Durable good have a long shelf life and can be stored example furniture , car etc. Perishable goods give a one shot service whereas durable goods can be used for several years.

Demand for perishable goods depends on convenience, style & income of the consumer. This demand is always immediate. Demand for durable goods depends on product design, current trends, income levels, price etc. this demand is postponable. • Autonomous and derived demand: Spontaneous demand for goods is based on a urge to satisfy some want directly, such a demand is called Autonomous demand. Demand for consumer goods is autonomous. It is a direct demand, it is a final demand . “When the demand of the product depends on the demand of some other product, it is called derived demand. When the demand of the product is tied to the purchase of some parent product its demand is called derived”(Dean 1976). Eg. Demand for doors derived from demand from houses., demand for bulbs derive from demand for lamps. Demand for dependent product is caused by complementary consumption. Example demand for sugar emerges from demand for tea. Demand for all capital goods are derived. Nowadays it is rare to see demand for goods to be wholly dependent of all other demands. Most demands are derived demands.

Example demand for car by an individual is derived from demand of transportation service. This distinction between two types of demand is a matter of degree. • Industry demand and firm / company demand : A firm is a business unit , where as industry is a group of closely competitive firms. A firms/company’s demand relates to the market demand for the firm’s output. An industry’s refers to the to the total demand for a commodity produced by a particular industry eg; Car industry, Sugar industry etc. The basic relationship of a firm’s demand and industry/market depends on the market structure whether perfect competition, monopoly or monopolistic competition. The elasticity of the demand curve will vary accordingly.

• Short run demand and Long run demand “Short run demand refers to existing demand with its immediate reaction to price changes ,income fluctuations etc., whereas long run demand is that which will ultimately exist as a result of the changes in pricing, promotion or product improvement ,after time is allowed to let market adjust itself to the new situations” (Dean 1976) In the short run the demand is not elastic (not very responsive to change) due to the following reasons D’ * Cultural lags in information/experience D X * Capital investment required of buyers to shift consumption patterns *Time adjustment involved-to change consumption patterns, habits, arrange for finance. Y

Joint demand and composite demand There are certain commodities the demand for which are interrelated. There are two types of interrelationships for such commodities. (1)Joint or complimentary: two goods that are demanded in conjunction with one another at the same time to satisfy the same want, such goods are said to be complimentary in nature. Eg. Bread / butter, cars/fuel, pen/ink, key/lock. (2)Composite demand: A commodity is said to be in composite demand when it is wanted for several different uses. Eg. Steel needed for cars, building,railways etc., Coal for factories, railways etc., wool for carpet, clothing etc., electricity for tv, radio etc. sugar for sweets, preservatives etc. A change in demand for the commodity by one user will affect its supplies to others and will bring about a change in its price and hence alter its demand pattern

Price demand, income demand, and cross demand. Price demand refers to the various quantities of a product purchased by a consumer at alternate prices D= f (p) where D-demand, f-functional relationship p- price of product Income demand refers to various quantities of a commodity demanded by the consumer at alternative levels of changing money income D = f (M) Where M –income varible Cross demand refers to the various quantities of a commodity (X) purchased by a consumer in relation to changes in price of a related commodity(Y), which maybe a substitute/complimentary product D x = f (P y) Where Dx –demand for X and Py –price of commodity Y

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