Dr.

Smita Shukla

DEMAND THEORY
DEMAND

 Demand is - Desire backed by ability and

willingness and to pay for.
 DEMAND VS. QUANTITY
DEMANDED

 Demand is the amount of a product that

people are willing and able to purchase at
each possible price during a given period of
time.

 The quantity demand is the amount of a

product that people are willing and able to
purchase at one, specific price.
THE LAW OF DEMAND

 Law of demand – there is an inverse

relationship between price and quantity
demanded.

 Quantity demanded rises as price falls provided

other things remain constant.
 Quantity demanded falls as prices rise provided
other things remain constant.
THE DEMAND CURVE

 The demand curve is the graphic

representation of the law of demand.

 The demand curve slopes downward from left

to the right indicating that ;
 As the price goes up, the quantity demanded
goes down.
A SAMPLE DEMAND CURVE
Price (per unit)

PA A

D
0
QA
Quantity demanded (per unit of time)
THE LAW OF DEMAND

 The demand curve is downward sloping for the

following reasons:

 At lower prices, existing buyers may buy more.

 At lower prices, new buyers may also enter the
market.
EXCEPTIONS TO ‘LAW OD DEMAND’
 When the price of a good is already too low then small
increase in its price may not reduce its demand.
 When the good is by perception is an ‘Inferior Good’
then any fall in its price may not increase its demand.
Such goods are also termed as ‘Giffen Goods’.
 Luxury goods
 Fear of Scarcity of the Good in near future may lead to
its demand going up even if its price is rising.
 Goods of which people are habituated. Example Liquor,
Cigarettes etc
OTHER THINGS CONSTANT

 Rule ‘Other things remain constant’ - places a

limitation on the application of the law of
demand.

 Allother factors that affect quantity demanded are

assumed to remain constant.
 These other factors can be ; Income, Prices of
related goods, fashion, Advertisement, population,
season etc
OTHER DETERMINANTS OF DEMAND

Income

Tastes

Prices of Related Goods

Population

Season

Fashion etc
 Shifts in Demand Versus
Movements Along a Demand
Curve

 A movement along a demand curve is the

graphical representation of the effect of a
change in price on the quantity demanded.
 Shifts in Demand Versus
Movements Along a Demand
Curve

 A shift in demand is the graphical

representation of the effect of anything other
than price on demand.
CHANGE IN QUANTITY DEMANDED

$2 B
Price (per unit)

Change in quantity demanded

(a movement along the curve) on
account of change in Price
A
$1

D1
0
100 200
Quantity demanded (per unit of time)
SHIFT IN DEMAND

Change in demand
(a shift of the curve)
$2 on account of change
Price (per unit)

in factors other than

price
B A
$1

D0

D1
100 200 250
Quantity demanded (per unit of time)
SHIFT FACTORS OF DEMAND

 Shift factors of demand are factors that cause

shifts in the demand curve:
 Change in Income.
 Change in the prices of other goods.

 Change in Tastes.

 Change in Expectations.

 Change in Number of Buyers

 Taxes on subsidies to consumers etc.

FACTORS THAT SHIFT DEMAND

Number
Of
Buyers
Consumer Price of
Income Related Goods

Demand
Tastes
And Expectations
Preferences

Demographics
THE CONCEPT OF ELASTICITY

 Elasticity is a measure of the responsiveness of

one variable to another.
 The greater the elasticity, the greater the
responsiveness.
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 demanded

ED =
Percentage change in price
SIGN OF PRICE ELASTICITY
 According to the law of demand, whenever
the price rises, the quantity demanded falls.
Thus the price elasticity of demand is always
negative.

 Because it is always negative, economists

usually state the value without the sign.
 COMPUTING THE PRICE ELASTICITY OF
DEMAND
The price elasticity of demand is computed as the
percentage change in the quantity demanded
divided by the percentage change in price.

Price Elasticity = Percentage Change in Qd

Of Demand Percentage Change in Price

CLASSIFYING DEMAND AND SUPPLY AS ELASTIC
OR INELASTIC

 Demand is termed to be elastic if the

percentage change in quantity is greater than
the percentage change in price.

E>1
CLASSIFYING DEMAND AND SUPPLY AS ELASTIC
OR INELASTIC

 Demand is termed to be inelastic if the

percentage change in quantity is less than the
percentage change in price.

E<1
DEFINING ELASTICITIES

 When price elasticity is between zero and -

1 we say demand is inelastic.
 When price elasticity is between -1 and
- infinity, we say demand is elastic.
 When price elasticity is -1, we say demand is
unit elastic.
ARC (PRICE) ELASTICITY

P
Note that if we increased
the price,
(from 8 to 10 or 2 to 4)
a
the original P and Q 10 b
would be 2 and 8 and 8
18 and 90,
respectively. 4
c
2 d
Ep = (-10/18)/(2/8) = -2.22 D
8 18 80 90 Q
Ep = (-10/90)/(2/2) = -.11
THE END-POINT PROBLEM

 Economists use the average of the end

points to calculate the percentage change.

(Q2 - Q1)
½Q2  Q1 
Elasticity = (P 2 - P1)
½P1 + P2 
GRAPHS OF ELASTICITIES

B
$26
24 C (midpoint)
22 A
20
18
D
16
14 Elasticity of demand
between A and B = 1.27
0 10 12 14
Quantity of software (in hundred thousands)
 CALCULATING ELASTICITIES: PRICE
ELASTICITY OF DEMAND

P What is the price elasticity of

demand between A and B?
Q2–Q1
%ΔQ ½(Q2+Q1)
B
ED = %ΔP
= P2–P1
$26 Midpoint
C ½(P2+P1)
$23
$20 A 10–14
½(10+14) -.33
= 26–20 = .26 = 1.27
D ½(26+20)
Q
10 12 14
7-27
 ELASTICITY AND DEMAND CURVES

 Two important points to consider:

 Elasticity is related (but is not the same as)

slope.
 Elasticity changes along straight-line demand
and supply curves.
PERFECTLY INELASTIC DEMAND CURVE
ELASTICITY = 0

Perfectly inelastic
demand curve

0
Quantity
PERFECTLY ELASTIC DEMAND CURVE
ELASTICITY = INFINITE

Perfectly elastic
demand curve

0
Quantity
 RELATIVELY INELASTIC DEMAND
(ELASTICITY IS LESS THAN 1 BUT NOT ZERO)
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 UNIT ELASTIC DEMAND
(ELASTICITY EQUALS 1)
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
 RELATIVELY ELASTIC DEMAND
(ELASTICITY IS GREATER THAN 1 BUT NOT INFINITE)

Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
DEMAND CURVE
SHAPES AND ELASTICITY
 Perfectly Elastic Demand Curve
 The demand curve is horizontal, any change in price no matter how
small it may be can and will cause consumers to change their
consumption.

 Perfectly Inelastic Demand Curve

 The demand curve is vertical, the quantity demanded is totally
unresponsive to the price. Changes in price have no effect on
consumer demand.

 In between the two extreme shapes of demand curves are

the demand curves for most products.
 ELASTICITY ALONG A DEMAND CURVE
Ed = ∞
Elasticity declines along demand
$10 curve as we move toward the
9 quantity axis
8 Ed > 1
7
6 Ed = 1
Price

5
4
3 Ed < 1
2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10 Quantity
DETERMINANTS OF THE
PRICE ELASTICITY OF DEMAND
 The degree to which the price elasticity of
demand is inelastic or elastic depends on:
 How many substitutes there are
 How well a substitute can replace the good or
service under consideration
 The importance of the product in the
consumer’s total budget
 The time period under consideration
DETERMINANTS OF PRICE ELASTICITY OF
DEMAND

 Demand tends to be more inelastic

 If the good is a necessity.

 If the time period is shorter.

 The smaller the number of close substitutes.

 The more broadly defined the market.

 ELASTICITY AND TOTAL REVENUE
 Totalrevenue is the amount paid by buyers and
received by sellers of a good.
 Computed as the price of the good times the
quantity sold.

TR = P x Q
THE TOTAL REVENUE TEST FOR ELASTICITY

Increase in Decrease in
Total Revenue Total Revenue

Increase in INELASTIC ELASTIC

Price DEMAND DEMAND

Decrease in ELASTIC INELASTIC

Price DEMAND DEMAND
 INCOME ELASTICITY OF DEMAND
 Income elasticity of demand measures how
much the quantity demanded of a good
responds to a change in consumers’ income.

 Itis computed as the percentage change in the

quantity demanded divided by the percentage
change in income.
 COMPUTING INCOME ELASTICITY

Percentage Change
Income Elasticity = in Quantity Demanded
of Demand Percentage Change
in Income
 INCOME ELASTICITY
- TYPES OF GOODS -
 Normal Goods
 Income Elasticity is positive.
 Inferior Goods
 Income Elasticity is negative.

 Higher income raises the quantity demanded for

normal goods but lowers the quantity demanded for
inferior goods.
CROSS PRICE ELASTICITY OF DEMAND

 Elasticity measure that looks at the impact a

change in the price of one good has on the
demand of another good.

 Ec = % change in demand of X /% change in price of Y.

TYPES OF RELATED GOODS

 Substitutes

 Complementary Goods
CROSS ELASTICITY OF SUBSTITUTES

 Cross Elasticity of Substitutes is always

Positive.
 This because as the price of one good goes up
the demand of other increases
 Examples around us; Petrol and Diesel
CROSS ELASTICITY FOR COMPLEMENTARY
GOODS
 Cross Elasticity of Complementary goods is
always Negative.
 This because as the price of one good goes up
the demand of other decreases
 Examples around us; ‘Demand for Petrol based
Cars’ and the ‘Price of Petrol’