UNIT 4: THEORY OF DEMAND

Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Meaning
4.3 Types of Demand
4.4 Demand Schedule and Curve
4.5 Factors Determining Demand
4.6 Law of Demand
4.7 Summary
4.8 Answers to Check Your Progress
4.9 Model Examination Questions
4.10 References

4.0 AIMS AND OBJECTIVES

This unit discusses the meaning of demand types of demand, law of demand and
exceptions.

By the end of the unit, you will be able to:

 understand the meaning of demand;
 list out the types of demand;
 explain the law of demand;
 narrate the exceptions to law of demand.

4.1 INTRODUCTION

This unit attempts to determine the various factors, which will affect demand. It does not
only the law of demand, since it is misleading that it concentrates on price as the sole
determinant of demand. However, demand has multivariate relationship as it is derived
by money factors simultaneously. Some of the important determinants of the market
demand for a particular product or the price of the product itself, consumer’s income,
prices of other commodities in the market, consumer’s tastes income distribution, total

41
population, consumers wealth, credit availability, government policy, past levels of
demand and past levels of income. But the traditional theory of demand has discussed
only four the above determinants – the price of the commodity, the price of other
commodities, incomes and tastes.

4.2 MEANING

In our day-to-day life we use the word ‘demand’ in a loose sense to mean a desire of a
person to purchase a commodity or service. But in economics it has a specific meaning.
Demand implies more than a more desire to purchase a commodity. It states that the
consumer must be willing and able to purchase the commodity, which he desires. His
desire should be backed by his purchasing power. A poor person is willing to by a car, it
has no significance, since he has no ability to pay for it. On the other hand his desire to
buy the car must be backed by the purchasing power constituted demand. Demand, thus,
means the desire of the consumer for a commodity backed by purchasing power. These
two factors are essential. If a consumer is willing to buy but is not able to pay, his desire
will not become demand. Similarly, if the consumer has the ability to pay but is not
willing to pay, his desire will not be called demand.

Check Your Progress –1

1. What is a demand?
__________________________________________________________________
_________________________________.

4.3 TYPES OF DEMAND

There are three types of demand

a) Price demand
b) Income demand and
c) Cross demand
Price demand: - It refers to various quantities of a commodity or service that a consumer
would purchase at a given time in a market at various hypothetical prices. It is assumed

42
that other things such as consumer’s income, tastes and prices of interrelated goods
remain unchanged. The quantity demand of a particular commodity depends on the price
of that commodity.
Dx = f(Px)
Where Dx stands for commodity X
f denotes function
Px for price
The functional relationship between price and quantity demanded is well accepted.
Consumer behavior is so consistent economists fell justified in making the strongest
possible generalizations concerning the relationship between price and demand. The
relationship between price and demand is called inverse relationship. This relationship is
generalized by downward sloping demand curve.
y d
Price

Demand x

The functional relationship between quantity demand and price is illustrated with the help
of demand curve. In the above diagram, the price on the vertical axis and the quantity
demanded on the horizontal axis. The curve dd labeled as demand curve.

Income Demand
It refers to the various quantities of goods and services, which would be purchased by the
consumer at various levels of income. There is critical functional relationship between
income changes and changes in consumption quantity. This functional relationship is
defined as
Dx = f(y)
It means, the quantity of good X purchased is a function of consumer’s income. The
functional relationship between income and quantity demanded may be inverse or direct.
There is not great consistency of response by consumers with respect to quantity
variation for different goods as incomes change. Consequently, it is difficult to make

43
strange generalizations with respect to this functional relationship. In the case of superior
or normal goods, the demand will increase with the increase in incomes.

d
y

N1
N
Income
d
m m1 x
Demand

‘OX’ axis represents demand for superior or normal goods, while ‘OY’ axis represents
income. When the consumer’s income is on ON his demand is ‘OM’. But, when his
income increases from ON to ON1, the demand increases from ‘OM’ to OM 1Against this,
the demand for inferior commodity decreases with the increase in income. This
relationship is called inverse relationship.
y d
N1
Income

N
d

m m x

The above diagram tells that ‘ON’ income, the demand for the commodity is ‘OM’. But
when the consumer’s income increases from ON to ON1, the demand of the commodity
decreases from OM to OM1.

Cross Demand
Cross demand means the various quantities of commodities or services, which will be
purchased with reference to changes not of this commodity but of other interrelated
commodities. These goods are either substitutes or complementary goods. The correlation
between the demand for one commodity and the price of another may be positive or

44
 negative according to the manner in which these two commodities are related to each
other.

If the two commodities are substitutes, then obviously they satisfy the same want. The
more the consumer buys of one, the less he requires of the other. For example, tea, coffee
is good substitutes. If the price of tea increases the consumer may buy less of it as they
can buy more of coffee. Thus, a rise in the price of tea increases demand for coffee. A fall
in the price of tea on the other hand, may reduce the demand for coffee because the
consumers will now increase their intake of tea.

Price of Butter
y
d y d
Price of Tea

M1 N1

M
d N
d

x
N N1 O m m1 x
Demand for Coffee Demand for Bread

Substitute goods Complementary goods

4.4 DEMAND SCHEDULE AND CURVE

Demand Schedule:
A demand schedule can be constructed to any commodity of the lost of prices and
quantities purchased at those prices are know. An individual demand schedule is a list of
the various quantities of a commodity which an individual consumer purchases at various
levels of prices in the market. A demand schedule states the relationship between two
variables of price and quantity demanded.

Imaginary demand schedule for oranges

Price per dozen Quantity demanded
Birrs in Kgs.

45
 1 15
2 12
3 10
4 7
5 5

Demand curve:
y
5
Price

2
2
1

0 x
5 7 10 12 15
Demand

In the above diagram prices of oranges are given on ‘OY’ axis and demand ‘OX’ axis.
When the price per Kilogram is birr 1 only, 15 kilograms are demanded. If we plot the
data as above, you may notice that if the price falls down demand increases and vice-
versa.

4.5 FACTORS DETERMINING DEMAND

The following factors may determine demand

I. Change in fashions
II. Change in weather
III. Change in quantity of money in circulation
IV. Change in population
V. Change in wealth distribution
VI. Changes in technology
VII. Advertisement

46
4.6 LAW OF DEMAND

Law of demand tells us the functional relationship between the price of a commodity and
its quantity demanded in the market. It means that it shows us an inverse relationship
between the above two variables.

“The greater the amount to be sold, the smaller must be the price at which it is offered in
order that it may find purchasers; or in other words, the amount demanded increases with
a fall in the price and diminishes with a rise in price”. But the above law operates only
under the assumption that “other things remaining constant”. The above phrase implies
that when we state the law of demand, we assume
1) The income of consumer will not change
2) The tastes and fashions remain same
3) The price of other related commodities remain unchanged.

Exceptions
Giffen’s Paradox
As per the law of demand if the price increases the demand should decrease. But, some
time it may rise. In other words, some times people may buy more when the prices are
high. This was invested by Sir Robert Giffen.

Prestigious goods
Some times people purchase certain goods as their possession confers a higher social
status on them. For example diamonds and precious stones are purchased by rich people
to maintain high prestige in the society without caring for the high price of goods.

Speculation
Some times, the price of commodity might be increasing and it is expected to increase
still further. The consumers will buy more of the commodity at the higher prices than
they did at lower price. The increase in price may not be accompanied by a decrease in its
demand, which is contrary to the law of demand.

Check your progress –2

47
 1. Explain the law of demand.
__________________________________________________________________
_________________________________.

4.7 SUMMARY

Demand for a commodity depends on the willingness of a consumer and his purchasing
power. There are three kinds of demand price, income and cross demand.

Law of demands states when the price increases demand decreases and vice-versa. This
law has certain exceptions viz. Giffen’s paradox, prestigious goods and speculation.

4.8 ANSWERS TO CHECK YOUR PROGRESS

1. The term demand constitutes two things one is willingness of a consumer to buy
and should be backed by capacity to buy; otherwise it doesn’t mean that there is a
demand.
2. The law of demand says when the price of a commodity decreases, then the
demand increases and vice-versa.

4.9 MODEL EXAMINATION QUESTIONS

1. What do you mean by demand?

2. What are the determinants of demand?
3. Explain the law of demand.
4. What is Giffen’s paradox?

4.10 REFERENCES

48