Chapter 02 Theory of Demand

CHAPTER 2
Theory of Demand
The demand for a commodity is defined as a schedule of the quantities that buyers would be
willing and able to purchase at various possible prices per unit of time. Unit of time refers to
year, month, and week and so on. It should also be understood that demand is not the same thing
as desire or need. A ‘desire’ becomes ‘demand’ only when it is backed up by the ability and
willingness to satisfy it.
Demand Schedule: An individual’s demand schedule is a list of various quantities of a
commodity, which an individual consumer purchases at different (alternative) prices in the
market at a given time. The demand schedule, thus, states the relationship between the quantity
demanded of a commodity and its price. In a market, there are a number of consumers each with
his own demand schedule, showing the different quantities of the commodity that he will
purchase at different prices. The market demand schedule can be obtained in two ways. First, by
adding up the demand schedules of all the consumers in the market. Second, by taking the
demand schedule of the representative consumer and multiplying it by the total number of
consumers in the market.
Determinants of Demand:
The demand is influenced by the following factors:
a) Tastes and Preferences of the Consumer: The changes in demand for various goods
occur due to changes in fashion, and massive advertisement by the sellers.
b) Income of the People: The greater the incomes of the people, the greater will be their
demand for goods and vice versa. Thus, there is a positive relationship between income
and demand when all other factors are kept constant.
c) Price of the Commodity: Greater the price of the commodity, the lesser will be its
demand and vice-versa. Thus, there is a negative relationship between the price and
quantity demanded of a commodity, if all other factors remain constant.
d) Changes in the Prices of the Related Goods: When the price of a substitute for a good
X falls, the demand for that good X will decline and when the price of the substitute rises,
the demand for that good will increase. Tea and coffee are very close substitutes.
Therefore, when the price of tea falls, the consumers substitute tea for coffee and as a
result, the demand for coffee declines. For goods that are complementary with each other,
the change in the price of any of them would affect the demand of the other. For instance,
if the price of milk falls, its demand would rise. Along with the demand for milk, the
demand for sugar would also rise, as milk and sugar are complementary goods. Likewise,
when the price of car falls, the demand for them would increase which in turn will
increase the demand for petrol.
e) Population: As population increases, the number of consumers would also increase and
as a result, more of goods will be purchased.
f) Income Distribution: In a country with equitable distribution of income, there will be
lesser demand for certain luxury goods, while in a country where the income is unequally
divided among the very rich and very poor people, the demand for such luxury goods-
will be more.
g) Expectations about Future Prices: If consumers expect that the price of a good to rise
sharply in near future, they may buy more of that good now itself so as to avoid paying
higher prices later.
Law of Demand
The law of demand expresses the functional relationship between price and quantity of a
commodity demanded. The law of demand may be stated as follows: other things being equal, if
the price of a commodity falls, the quantity demanded of it will rise and if price of the
commodity rises, its quantity demanded will decline. Thus, according to the law of demand,
there is an inverse relationship between price and quantity demanded, other things remaining the
same.
These other things which are assumed to be constant are
a) Tastes and preferences of the consumer
b) Income of the consumer and
c) Prices of related goods (substitute and complementary goods).
If these other factors, which determine demand, also undergo a change, then the inverse price-
demand relationship may not be valid. The law of demand can be illustrated through a demand
curve (Fig.3.1). Suppose, the consumer purchases OQ0 quantity of rice for OP0. If price of rice
rises from OP0 to OP1 the quantity demanded decreases from OQ0 to OQ1. Similarly, if the
price falls from OP0 to OP2, the quantity demanded rises from OQ0 to OQ2. Thus, there is a
negative relationship between the price and quantity demanded. In other words, the demand
curve slopes downward from left to right.
The law of demand can be expressed in the functional form as follows:
Qd = f (P, I, PR/T)
Where,
Qd = Quantity demanded of a commodity
P = Price of the commodity
I = Income of the consumer
PR = Prices of the related goods
T = Tastes and preferences of the consumer
Extension and Contraction of Demand:

When the quantity demanded of a good rises due to the fall in price, it is called extension of
demand. When the price falls from OP0 to OP2, the quantity demanded increases from OQ0 to
OQ2. When the quantity demanded of a good decrease due to rise in the price, it is called
contraction of demand. When the price rises from OP0 to OP1, the quantity demanded of the
good decreases from OQ0 to OQ1. The extension and contraction of demand take place as a
result of changes in the price alone when other determinants of demand such as tastes, income
and prices of the related goods remain constant.
Increase and Decrease in Demand:
Now, if the other things, that is, determinants of demand other than price such as consumer’s
tastes and preferences, income and prices of the related goods change, the whole demand curve
will shift upward or downward. Increase in demand means that the consumer buys more of the
good at various prices than before. For example, if the income of a consumer increases, or if the
fashion for a good improves, the consumer will buy greater quantities of the good than before at
various given prices. The consumer will buy OQ5 rather than OQ0 due to upward shift or
increase in demand (see Fig.3.4). Similarly, the consumer will buy OQ4 instead of OQ0 due to
downward shift or decrease in demand. This increase and decrease in demand happen due to the
changes in factors other than price of the commodity.
The Market Demand for a Commodity:

The market demand for a commodity is obtained by adding up the total quantity demanded at
various prices by all the individuals over a specified period of time in the market. It is described
as the horizontal summation of the individuals‟ demand for a commodity at various possible
prices in market. In a market, there are a number of buyers for a commodity at each price. In
order to avoid a lengthy addition process, we assume here that there are only four buyers for a
commodity who purchase different amounts of the commodity at each price. The horizontal
summation of individuals‟ demand for a commodity will be the market demand for a commodity
as is illustrated in the following schedule:
Demand Schedule Demand schedule is a tabular representation of the quantity demanded of a
commodity at various prices. For instance, there are four buyers of apples in the market, namely
A, B, C and D.
PRICE (Rs. Buyer A Buyer B Buyer C Buyer D Market
per dozen) (demand in (demand in (demand in (demand in Demand
dozen) dozen) dozen) dozen) (dozens)
10 1 0 3 0 4
9 3 1 6 4 14
8 7 2 9 7 25
7 11 4 12 10 37
6 13 6 14 12 45
The demand by buyers A, B, C and D are individual demands. Total demand by the four buyers
is market demand. Therefore, the total market demand is derived by summing up the quantity
demanded of a commodity by all buyers at each price.
Exceptions to the law of demand:
Unlike other laws, law of demand also has few exceptions i.e. there is no inverse relationship
between price and quantity demanded for these goods. Few of them are as follows:
1. Giffen goods: These are those inferior goods whose quantity demanded decreases with
decrease in price of the good. This can be explained using the concept of income effect and
substitution effect
2. Commodities which are regarded as status symbols: Expensive commodities like jewellery,
AC cars, etc., are used to define status and to display one‟s wealth. These goods doesn‟t follow
the law of demand and quantity demanded increases with price rise as more expensive these
goods become, more will be their worth as a status symbol.
3. Expectation of change in the price of the goods in future: if a consumer expects the price of
a good to increase in future, it may start accumulating greater amount of the goods for future
consumption even at the presently increased price. The same holds true vice versa.

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CHAPTER 2

Extension and Contraction of Demand:

The Market Demand for a Commodity:

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