Term Paper

of
Managerial Economics

Topic: Demand, Determinants of Demand

and its Analysis

Submitted By:
Praveen Rai
Institute of Business Management,
C. S. J. M. U., Kanpur.

1
 INDEX
P
S
a
.
g
N Topic
e
o
N
.
o.
Demand
1. I. Meaning of Demand 3
II. Business Significance of Demand
4-
2. Types of Demand 5
5-
3. Determinants of Demand 6
4. Demand Function 6
Law of Demand
I. Assumption of the Law of
Demand
6–
5. II. Demand Schedule 10
III. Demand Curve
IV. Rationale for Law of Demand
V. Exception of the Law of Demand
Demand Analysis
I. Meaning of Demand Analysis
10
II. Marginal Utility Approach
6. –
III. Indifference Curve Analysis 13
IV. Revealed Preference Approach
V. Objectives of Demand Analysis

2
 13
7. Conclusion -
14
8. Bibliography 14

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 Demand
Meaning of Demand:-
Conceptually, the term ‘Demand’ implies a ‘desire for a
commodity backed by the ability and willingness to
pay for it’.

The concept of demands refers to the quantity of a good

or service that consumers are willing and able to purchase at
various prices dealing a period of time. The demand in
economics is something more than desire to purchase though
desire is one element of it. A beggar for instance, may desire
food, but due to lack of means to purchase it, his demand is
not effective. In economics, demands refer to effective
demand, which implies three things (i) Desire (ii) means to
purchase and, (iii) on willingness to use those means for that
purchase. 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.

A meaningful statement regarding the demand for a

commodity should contain the following information:

I. the quantity demanded of a commodity,

II. the price at which a commodity is demanded,
III. the time period over which a commodity is demanded
and
IV. the market area in which a commodity is demanded.

For example, saying, ‘the annual demand for TV sets in

Delhi at an average price of Rs. 15,000 a piece is 50,000’ is a
meaningful statement.

Business Significance of Demand:-

The market for a firm’s product cannot be analyzed
without reference to the demand condition. For a firm or an
industry consisting of several firms, the extent of demand
determines the size of market. Successful business firms,
therefore, spend considerable time, energy and effort in
analyzing the demand for their products. Without a clear
4
understanding of consumers’ behavior and a clear knowledge
of the market demand conditions, the firm is handicapped in
its attempt towards profit planning or any other business
strategy planning. For example, estimating present demand
and forecasting future demand constitutes the first step
towards measuring and determining the flow of sales
revenues and profits which generate internal resources to
finance business. The stability and growth of business is
linked to size and structure of demand.

Types of Demand
1. Individual and Market Demand: The quantity of a
commodity which an individual is willing to buy at a
particular price of the commodity during a specific time
period, given his money income, his taste, and prices of
other commodities (particularly substitutes and
complements), is known as ‘individual’s demand for a
commodity’.

The total quantity which all the consumers of a

commodity are willing to buy at a given price per time unit,
given their money income, taste, and prices of other
commodities (mainly substitutes) 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, over a
time period, and at a given price, other factors remaining
the same.

2.Demand for Firm’s Product and Industry’s

Products: The quantity of a firm’s produce that can be
disposed of at a given price over a time period, and at a
given price, other factors remaining the same.

3. Autonomous and Derived Demand: Autonomous

Demand for a commodity is one that arises independent of
the demand for any other commodity whereas derived
demand is one that is lied to the demand for some ‘parent
5
product’. Demand for food, clothes, shelter etc. is
autonomous demand. Demand for land, fertilizers, and
agricultural tools and implements are a derived demand,
for these goods are demanded because food is demanded.

4. Demand for Durable and non-durable Goods:

Demand is often classified also under demand for durable
and non-durable goods. Durable goods are those. Whose
total utility (or use) is not exhausted by a single use. Such
goods can be used repeatedly or continuously over a
period. Durable goods may be consumer as well as producer
goods. Durable consumer goods include clothes, shoes,
owner occupied residential houses, furniture, utensils,
refrigerators, scooters, cars, etc. The durable producer
goods include mainly the items under ‘fixed assets’, such as
building, paint, machinery, etc.

Non-durable goods on the other hand, are those, which

can be used or consumed only once (for example, food
items) and their total utility is exhausted in a single use.

5. Short-term and Long-term Demand:

Short-term
demand refers to the demand for such goods as are
demanded over a short period. In this category fall mostly
the fashion consumer goods, goods of seasonal use, inferior
substitutes during the scarcity period of superior goods,
etc.

The long-term demand, on the other hand, refers to the

demand, which exists over a long period. The change in
long-term demand is perceptible only after a long period.
Most generic goods have long-term demand. For
example, demand for consumer and producer goods,
durable and non-durable goods, is long-term demand,
though their different varieties or brands may have only
short-term demand.

Determinants of Demand
6
 1. Price of the commodity: Ceteris paribus i.e., other
things being equal, the demand of a commodity is inversely
related to its price. It implies that a rise in price of a
commodity brings about a fall in its purchase and vice-
versa. This happens because of income and substitution
effects.

2. Income of the households: Other things being equal,

the demand for a commodity depends upon the income of
the household. In most cases, the larger the average
income of the household, the larger is the quantity
demanded of a particular good.

3. Price of the related goods: Related commodities are

of two types: (a) Complementary goods and (b) Completing
goods or substitutes. Complementary goods are those
goods, which are consumed together or simultaneously. For
example, tea and sugar, automobiles and petrol, pen and
ink are used together. When commodities are complements,
a fall in the price of one (other things being equal) will
cause the demand of the other to rise.

4. Tastes and preferences of consumers: The demand

for a commodity also depends upon tastes and preferences
of consumers and changes in them over a period of time.
Goods, which are more in fashion command higher demand
than goods, which are out of fashion.

5.Other factors:
I. Size of population: Generally, larger the size of
population of a country or region, greater is the demand for
commodities in general.

II. Composition of population: If there are more old

people in a region, the demand for spectacles, walking sticks,
etc. will be high. Similarly, if the population consists of more
of children, demand for toys, baby foods, toffees, will be
more.

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III. Distribution of Income: The wealth of the country
may be so distributed that there are a few exceptionally rich
people while the majority are exceedingly poor. Under such
conditions, the propensity to consume of the country will be
relatively less, for the propensity to consume of the rich
people is less than that of the poor people. Consequently, the
demand for consumer goods will 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.

Apart from the above factors such as class, group,

education, marital status and weather conditions, also play an
important role in influencing household demand.

Demand Function
The above listed factors can easily be presented in the
form of a demand function as follows:
Qdc = f (Pc, Pr, Y, T, D,)
Where Qdc is the quantity demanded of commodity c, Pc is
the price of commodity c, Pr is the price of commodities, Y is
the money income of the household, T is the taste of the
household, D represent size of the population and other
remaining factors.

Law of Demand
The demand for a commodity increases with fall in its
price and decreases with the rise in its price, other thing
remaining the same. The law of demand thus merely states
that the price and the demand of a commodity are inversely
related, provided all other things remain unchanged.

Assumptions of the Law of Demand:-

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1. Income level should remain constant: The law of
demand operates only when the income level of the
buyer remains constant. If the income rises while the
price of the commodity in question does not fall, it is
quite likely that the demand may increase. Therefore,
stability in income is an essential condition for the
operation of the law of demand.

2. Tastes of the buyer should not change: Any change

that takes place in the tastes of the consumers will in all
probability prevent the working of the law of demand. It
often happens that when tastes or fashions change
people revise their preferences.

3. Price of other goods should remain constant:

Changes in the prices of other goods often affect the
demand for a particular commodity. If prices of
commodities for which demand is inelastic rise, the
demand for a commodity other than these in all
probability will decline even though there may not be any
change in its price. Therefore, for the law of demand to
operate it is very necessary that prices of other goods do
not change.

4. No New substitutes for the commodity: If some new

substitutes for a commodity appear in the market, its
demand generally decline. This is quite natural, because
with the availability of new substitutes some buyers will
be attracted towards new product and the demand for
the older product will fall even though price remains
unchanged. Hence, the law of demand operates only
when the market for a commodity is not threatened by
new substitutes.

5. Price rise in future should not be expected: If the

buyers of a commodity expect that its price will rise in
future they raise its demand in response to an initial
price rise. This behaviour of buyers violates the law of
demand. Therefore, for the operation of the law of
demand it is necessary that there must not be any
expectations of price rise in future.

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 The law of demand may be illustrated with the help of a
demand schedule and a demand curve.

Demand Schedule:-
The demand schedule thus shows the effect of price
changes on the quantity sold in the market to the exclusion of
all the factors.

Quantity
Price of
Commodity Demanded
Commodity (Rs.)
(Units)
A 5 10
B 4 15
C 3 20
D 2 35
E 1 60

Demand Curve:-
The graphical representation of the demand schedule is
the demand curve. Individual demand curve indicates the
quantity of the commodity that an individual will buy at
different prices. It is customary in economics to measure a
price along ‘Y’ axis and quantity demanded on ‘X’ axis.

5 A

4 B
Price

3 C

2 D

E
1

0 X
10 20 30 40 50 60

Quantity
10
 Fig. 1: Demand Curve
The curve slopes downward. Any point on the graph
indicates a single price quantity relation. The whole demand
curve DD1 shows the quantity of commodity N that would be
bought by an individual at different prices.

Rationale for Law of Demand: Why does demand

curve slope downwards?
1. Substitution Effects: When the price of a commodity
falls, it becomes relatively cheaper than other
commodities. It includes consumers to substitute the
commodity whose price has fallen for other commodities,
which have now become relatively expensive. The result
is that total demand for the commodity whose price has
fallen increases. This is called substitution effect.

2. Income Effects: When the price of commodity falls, the

consumer can buy the same quantity of the commodity
with lesser money or he can buy more of the same
commodity with the same money. In other words, as a
result of fall in the price of the commodity, consumer’s
real income or purchasing power increases. This increase
in the real income includes him to buy more of that
commodity. Thus demand for that commodity (whose
price has fallen) increases. This is called income effect.

3. New Consumer Creating Demand: When the price of

a commodity falls, more consumers start buying it
because some of those who could not afford to buy it
previously may afford to buy it. This raises the number of
consumers of a commodity at a lower price and hence the
demand for the commodity in question.

Exception of the Law of Demand:-

According to law of demand, more of a commodity will be
demanded at lower prices, than at higher prices, other things
being equal. The law of demand is valid in most of the cases;
however there are certain cases where this law does not hold
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good. The following are the important exceptions to the law of
demand.

1. Conspicuous goods: Some consumers measure the

utility of a commodity by its price i.e., if the commodity is
expensive they think that it has got more utility. As such,
they buy less of this commodity at low price and more of it
at high price. Diamonds are often given as example of this
case. Higher the price of diamonds, higher is the prestige
value attached to them and hence higher is the demand for
them.

2. Giffen goods: Sir Robert Giffen, and economist, was

surprised to find out that as the price of bread increased,
the British workers purchased more bread and not less of it.
This was something against the law of demand. Why did
this happen? The reason given for this is that when the
price of bread went up, it caused such a large decline in the
purchasing power of the poor people that they were forced
to cut down the consumption of meat and other more
expensive foods. Since bread even when its price was
higher than before was still the cheapest food article,
people consumed more of it and not less when its price
went up.

Such goods which exhibit direct price-demand relationship

are called ‘Giffen goods’. Generally, those goods which are
considered inferior by the consumers and which occupy a
substantial place in consumer’s budget are called ‘Giffen
goods’. Examples: such goods are coarse grains like bajra,
low quality of rice and wheat etc.

3. Conspicuous necessities: The demand for certain

goods is affected by the demonstration effect of the
consumption pattern of a social group to which an
individual belongs. These goods, due to their constant
usage, have become necessities of life. For example, in
spite of the fact that the prices of television sets,
refrigerators, coolers, cooking gas etc. have been
continuously rising, their demand does not show any
tendency to fail.

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 4. Future expectations about prices: It has been
observed that when the price are rising, households
expecting that the prices in the future will be still higher,
tend to buy larger quantities of the commodities. For
example, when there is wide-spread drought, people expect
that prices of food-grains would rise in future. They demand
greater quantities of food-grains as their price rise.

5. Impulsive purchases: At times consumers tend to

make impulsive purchases without any cool calculations
about price and usefulness of the product and in such
contexts the law of demand fails.

6. Ignorance effect:Generally, it is assumed that

households have perfect knowledge about price and quality
of goods. However, in practice, a household may demand
larger quantity of a commodity even at a higher price
because it may be ignorant of the ruling price of the
commodity.

Demand Analysis
Meaning of Demand Analysis:-
There are a large number of factors, which have a direct
impact on the demand of a commodity or service. Demand
analysis means the study of factors, which influence the
demand of a commodity or service. It is only on the basis of
these factors or determinants of demand one can forecast
demand. Under demand analysis we study elasticity of
demand and methods of its measurement, sales forecasts and
different methods to forecast sales or demand, manipulating
demand and appropriate change in allocation of resources.
Analysis of demand enables the producer to adjust his
production to the demand to maximize the objective function.

Economists have developed several techniques of

analyzing demand. Econometricians have tested some of the
propositions underlying the economic theory of demand as
developed by the economists. Of late, in the name of

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psychological economics, the behavioral scientists have
attempted explanation as well as psychometric measure of
consumer’s behavior. Following are the approaches for
analyzing the demand:

1.Marginal Utility (Neo-Classical)

Approach:-
It is a traditional approach used by Marshall and Jevons
to explain the consumer behavior. Consumers demand
commodity because they derive or expect utility from the
consumption of that commodity. The utils (utility-content of
product) indicate ‘value-in-use’ and they command price in
the market; the price paid indicates the ‘value-in-exchange’.
Sometimes we observe that products with tremendous ‘value-
in-use’ do not command any ‘value-in-exchange’ i.e., those
are “free goods” like air, water available in plenty at ‘no
price’ because there is no scarcity. Utility along with scarcity
determines price. Diamond is not that useful, but being rare it
is very valuable; therefore, such “economic goods” command
a high price.

Economists assume that the utils are cardinally

measurable and comparable in terms of a measuring unit of
money, provided the utility of that money is held constant. A
consumer, while purchasing a commodity often compares his
sacrifice (in terms of price paid0, i.e., value-in-exchange with
his satisfaction. If price exceeds marginal utility, he
reduces his purchase. If marginal utility exceeds price,
he enhances his purchase. Ultimately when price equals
marginal utility, he is in an equilibrium state of his
purchase decision.

Marginal utility of product

Marginal Utility of money spent =
---------------------------------------
Price of the product

MUx
[MUm = ----------]
Px

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 2.Indifference Curve (Ordinal Utility)
Approach:-
This approach has been developed by the economists like
Hicks and Allen to overcome some of the limitations of Neo-
Classical approach. Assuming ordinal measurement of utility
and relatedness of goods and relaxing the assumption of
constant marginal utility of money, the technique of
indifference analysis has been developed.

We start with a multi-commodity consumer rather than a

single commodity consumer, typical of traditional utility
approach. Thus, the utility function is stated as: U = U (X, Y)
where x and y stand for two products.

The consumer wants to purchase of combination of x

(say, cereals) and y (say, vegetables). With given resources
and given need, whenever he buys more of x he has to be
satisfied with less of y. The rate at which this substitution
takes place is termed as the Marginal Rate of Substitution,
MRS which measures the slope of the Indifference curve

ΔY dY
MRSxy = ---------- OR -------
ΔX dX

Even if the consumer moves from combination A to B

there is no change in his satisfaction level, because the
utility-content of the bundle as a whole is intact; more of x
may reduce the utility of x, but less of y may have increased
the utility of y. This follows from the Law of Diminishing
Utility. Each indifference curve can, therefore, be treated as
an iso-utility curve.

3. Revealed Preference Approach:-

Indifference curve analysis is a powerful tool, but beyond
a point it cannot be stretched. Today, the businessmen have
to understand the buyer’s behavior from the standpoint of
more of psychology than of economics.

15
 A consumer buys a combination of x and y; his choice
takes care of his “preferences” as well as his “constraints”.
What is desirable may not always be available and feasible.
Therefore while choosing, he balanced the two. Does this
choice reveal his preference? Yes it does, provided the
following axioms are satisfied:

1. Choice set is complete. Before the buyer exercises his

choice, he takes into account all available choices.

2. Choice is rational. Rationality on the part of the

chooser implies that he is never satisfied (non-
satisfied) and that he wants to get the best
satisfaction out of his least scarifies.

3. Choice is optimal. Optimally means that either he

maximizes his satisfaction or he minimizes his
sacrifice, if there is no constraint.

4. Choice is strongly ordered.

5. Choice is transitive.

6. Choice is consistent.

It the above axioms are satisfied, then only Choice

reveals preference. It should now be clear that the demand
analyst cannot use terms like demand, need preference,
ordering, choice, etc., interchangeably.

Objectives of Demand Analysis:-

1. To study and analyze the determinants of demand.
2. To measure the elasticity of demand.
3. To prepare sales or demand forecasts.
4. Manipulating demand.
5. To make appropriate changes in allocation of resources.

Conclusion
16
 • ‘Demand’ implies a ‘desirefor a commodity
backed by the ability and willingness to pay for
it’.

• The Law of Demand holds that other things equal, as

the price of a good or service rises, its quantity
demanded will fall, and vice versa.

• A Demand Curve is a graphical depiction of the law

of demand. It has a negative slope.

• A change in price results in a movement along a

fixed demand curve. A change in any variable other than
price that influences quantity demanded produces a shift
in the demand curve.

• A shift in the demand curve to the right (left) results

in a higher (lower) equilibrium price and quantity.

• The demand curve shifts to the right when incomes

rise, population increases, preferences increase, the
price of a substitute rises, or the price of a complement
falls.

• Under Demand Analysis we study elasticity of

demand and methods of its measurement, sales forecasts
and different methods to forecast sales or demand,
manipulating demand and appropriate change in
allocation of resources. Analysis of demand enables the
producer to adjust his production to the demand to
maximize the objective function.

Bibliography
S.
Page
No Book Name Author Publisher
No.
.
1. Business Economics 178 –
182, 199
17
 - 208
104,
115,
Vikas 120 –
Managerial D. N. Publishing 126, 131
2.
Economics Dwivedi House Pvt. – 133,
Ltd. 153,
160 –
163
3. www.Wikipedia.org - - -
www.OnlineTexts.c
4. - - -
om
http://www.bized.co
5. - - -
.uk

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