Unit 2
• Theory of Demand
INTRODUCTION
• How much to produce and what price
to charge?
• Factors determining demand for a
product.
• Explores the relationship between
price and demand for a product.
• Examines likely impact of the potential
factors that influence its demand.
WHAT IS DEMAND?
The quantity of a product consumers are willing and able to
buy at different prices in a specified time period.
Types of Demand
-Direct and derived demands
-Individual and market demand
-Recurring and replacement
-Complementary and competing
-New and replacement demands
DETERMINANTS OF DEMAND
• Price of Product (Px)
• Income of Consumer (Yield / Y)-
– Essential consumer goods
– Normal consumer goods
– Inferior consumer goods
– Prestige & Luxury goods
• Price of Related Good(Pr)
– SUBSTITUTE GOODS
– COMPLEMENTRY GOODS
• Tastes and Preferences(T)
• Advertising
• Consumer’s expectation of future Income and Price (E)
• Growth of Economy/Population/ Distribution of Income (Yd)
DEMAND SCHEDULE
• It shows the price and output relationship.
• Tabular representation of price and demand.
DEMAND CURVE
• The geometrical representation of demand
schedule is called the demand curve.
LAW OF DEMAND
• As the price of a good rises, quantity demanded
of that good falls.
• As the price of a good falls, quantity demanded
of that good rises.
• Ceteris paribus.
DEMAND FUNCTION
• When we express the relationship between demand
and its determinant mathematically, the relationship
is known as demand function.
• The demand for product X can be written in
functional form as-
Dx= f (Px, Pr, Y, T, E, Yd)
EXCEPTIONS TO THE LAW OF DEMAND
• Inferior Goods
• Veblen Goods
• Snob Appeal (Peer Impact)
• Future Expectation of Prices
CHANGE IN DEMAND (Shift in
Demand Curve)
• A shift of the entire demand curve to a new position is
called change in demand.
• Changes in non-price determinants of demand.
CHANGE IN QUANTITY DEMANDED
(Movement along with Demand Curve)
• Fluctuations in price, another determinant of demand,
cause movement along the demand curve.
Change in Qty. Demanded/ Movement
• Extension of Demand Curve
• Contraction in the Demand Curve
Change in Demand concepts (Increase or Decrease)
Increase in Demand Curve
• Same Price More Demand
• More Price Same Demand
Decrease in Demand Curve
• Same Price Less Demand
• Less Price Same Demand
Change in Demand
Increase in Demand / Decrease in Demand
Increase
Due to various Reasons other than Price
likewise: Pr, Y, T, E, Yd
CASELET
Situation 1
• RAJNISH STAYS IN A COLLEGE HOSTEL. HE USED TO GET A
STIPEND OF RS 5000 PER MONTH FROM HIS FATHER.
RECENTLY, HIS FATHER HAS BECOME MORE GENEROUS
AND GIVES HIM RS 7000.
• WE OBSERVE THAT RAJNISH IS GOING TO A LOT MORE
MOVIES THAN BEFORE BUT EATING LESS AT THE NEARBY
CANTEEN. THERE ARE NO CHANGE IN THE MOVIE
TICKETS PRICES OR THAT OF THE FOOD AT THE CANTEEN.
FROM THIS, CAN WE SAY THAT BOTH MOVIES AND FOOD
AT THE CANTEEN ARE NORMAL GOODS FOR RAJNISH.
Situation 2
• There are train and bus services between
Delhi and Agra. Suppose the train fares
between the two cities come down. How will
it affect the demand for bus travel between
the two cities? Which determinant of demand
is at work here?
Situation 3
• How would a speculation that petrol price is
going to be doubled in two days affect your
demand for petrol today and why?
Situation 4
• Suppose there is an unexpected weather
forecast that a huge cyclone is going to hit
your town in the next three days. What could
be the anticipation from the people’s point of
view regarding the basic needs of life. Show it
through a diagram .
• What is Veblen effect, Bandwagon effect, snob
effect and Giffin’s effect.
ELASTICITY OF DEMAND
• Elasticity of demand is defined as the responsiveness of
the quantity of a good to changes in one of the variables
on which demand depends-
Price of the commodity
Income of the Consumer
Various other factor
DEFINATION-’’The elasticity of demand measures the
response of the demand for the commodity to change in
price”.
PRICE ELASTICITY OF DEMAND
• The price elasticity of demand is the
percentage change in quantity demanded
divided by the percentage change in price.
Percentage change in quantity dem anded
Price elasticity of dem and =
Percentage change in price
PRICE ELASTICITY OF DEMAND
Q / Q Q P
Point Definition EP
P / P P Q
Perfectly Inelastic Demand: Elasticity Equals 0 city
of Demand
Price
Demand
$5
4
1. An
increase
in price . . .
0 100 Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning
Inelastic Demand: Elasticity Is Less Than 1
Price
$5
4
1. A 22% Demand
increase
in price . . .
0 90 100 Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
1. A 22% Demand
increase
in price . . .
0 80 100 Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
Elastic Demand: Elasticity Is Greater Than 1
Price
$5
4 Demand
1. A 22%
increase
in price . . .
0 50 100 Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Perfectly Elastic Demand: Elasticity Equals
Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4 Demand
2. At exactly $4,
consumers will
buy any quantity.
0 Quantity
3. At a price below $4,
quantity demanded is infinite.
Case let
• The demand for apples in a small town was
200 kg when the price was Rs 20 per kg. It
expanded to 250 kg when the price was
reduced to Rs. 18 per kg. What is the elasticity
of demand for apples in the town?
• A private hospital, Get well, was charging Rs 2
lakh for a double-by pass heart surgery and it
was generating Rs 36 lakh revenue from it per
month. It has increased its rate to Rs 3.5 lakh
and now it is generating Rs 32 lakh revenue
from it. What can we say about the price
elasticity of demand for double by pass
surgery at Get Well.
Renuka used to consume 10 ice-creams a month
when the price of an ice-cream was Rs 30. It has
become more expensive with Rs 45 a piece. She
now consumes 8 ice creams in a month. What is
the Ep of demand for ice-crème by her?
INCOME ELASTICITY
• The degree of responsiveness of the demand
for the commodity to a change in the income of
the consumer.
• It is defined as Ratio of percentage change in
the quantity demanded of a commodity to the
percentage change in the income of consumer
INCOME ELASTICITY
• Negative ( inferior commodities )
• Zero ( neutral commodities )
• Greater than zero but less than 1( normal
commodities )
• Greater than unity ( Luxurious commodity )
INCOME ELASTICITY
Q / Q Q I
• Point EI
Definition I / I I Q
Cross Elasticity of Demand (CED)
• Cross price elasticity (CED) measures the
responsiveness of demand for good X following a
change in the price of good Y (a related good)
• CED = % change in quantity demanded of product A
% change in price of product B
• With cross price elasticity we make an important
distinction between substitute products and
complementary goods and services.
Price of
Good S
Substitutes
Two Weak Substitutes +
Demand Goods S and T are
weak substitutes
P2
A rise in the price of
Good S leads to a
small rise in the
P1
demand for good T
tea and coffee
Quantity demanded of
Good T
Complements
Price of
Good X Demand
-
Two Close Complements
Goods X and Y are
close complements P1
P2
A fall in the price of
good X leads to a
large rise in the
demand for good Y
Quantity demanded of
Petrol and Good Y
petrol car
Goods with zero cross-price elasticity of
demand . INDEPENDENT
Price of Demand
Good A
Goods A and B have no
relationship.
P1 A fall in the price of good A
leads to no change in the
demand for good B
P2 Therefore the cross-price
elasticity of demand is zero
P3
salt!
Quantity demanded of
Good B
Practical Problems
Yesterday, the price of envelopes was Rs 3 a box,
and Mr. J was willing to buy 10 boxes. Today, the
price has gone up to Rs 3.75 a box, and he is
now willing to buy 8 boxes. Is J’s demand for
envelopes elastic or inelastic? What is J's
elasticity of demand?
• Which of the following goods are likely to have
elastic demand, and which are likely to have
inelastic demand?
Home heating oil
Pepsi
Chocolate
Water
Heart medication
Oriental rugs
Kim advertises to sell cookies for Rs 40 a dozen.
She sells 50 dozen, and decides that she can
charge more. She raises the price to Rs 60 a
dozen and sells 40 dozen. What is the elasticity
of demand?
• Would the elasticity of demand in the
following cases be unity, less than unity or
greater than unity?
(i) A rise in the price of a commodity increases
the total household expenditure on it.
(ii) A rise in the price of commodity reduces
total household expenditure on it.
Methods of Measuring Elasticity of Price
• Total Expenditure Method
• Proportionate Method
• Point Elasticity Method
• Arc Elasticity Method
• Revenue Method
Importance of Price Elasticity of Demand
• Determination of Price under Monopoly
• Price Determination
• Price determination of Joint Supply
• Advantage to Finance Minister
• Distribution of Burden of Taxation
• International Trade
• Importance for the policy of Nationalization
• Wage Determination
• Paradox of Poverty
• Effect on Employment
