BY- Dr.

JATIN KUMAR LAMBA CA-FOUNDATION THEORY OF DEMAND & SUPPLY

CHAPTER2 THEORY OF DEMAND AND SUPPLY

MEANING OF DEMAND

The concept ‘demand’ refers to the quantity of a good or service that consumers are willing and
able to purchase at various prices during a period of time. It is to be noted that demand in
Economics is something more than desire to purchase though desire is one element of it. Thus
effective demand for a thing depends on

(i) desire
(ii) means to purchase and
(iii) on willingness to use those means for that purchase.

Unless demand is backed by purchasing power or ability to pay, it does not constitute demand.
Two things are to be noted about quantity demanded: The quantity demanded is always
expressed at a given price. At different prices different quantities of a commodity are generally
demanded. Second thing is that quantity demanded is a flow.

WHAT DETERMINES DEMAND?

There are a number of factors which influence household demand for a commodity:

(i) 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.

(ii) Price of related commodities: Related commodities are of two types:

(a) complementary goods and (b) competing 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. For example, a fall in the price of
cars would lead to a rise in the demand for petrol. There is an inverse relation between
change in price of one complement and demand of other complementary good.

Competing goods or substitutes are those goods which can be used with ease in
place of one another. For example, tea and coffee, ink pen and ball pen, are
substitutes for each other and can be used in place of one another easily. There is
positive relation between change in price of one substitute and demand of other
substitute i.e. a fall in price of one leads to a fall in the quantity demanded of its substitutes
and vice-versa.

(iii) Level of income of the household: Other things being equal, the demand for a
commodity depends upon the money income of the household. The larger the average
money income of the household, the larger is the quantity demanded of a particular good.
However, there are certain commodities for which quantities demanded decrease with an
increase in money income like Inferior goods. for necessities the increase will be less than
proportionate to the increase in income.

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(iv) Tastes and preference 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.

(v) Other factors : Apart from the above factors, the demand for a commodity depends upon
the following factors :
(a) Size of population : Generally, larger the size of population of a country or a region,
greater is the demand for commodities in general.
(b) 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.
(c) Distribution of income : The wealth of a country may be so distributed that there are a
few very rich people while the majority are very 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.

LAW OF DEMAND
The law of demand is one of the most important laws of economic theory. According to law of
demand, other things being equal, if the price of a commodity falls, the quantity
demanded of it will rise and if the price of a commodity rises, its quantity demanded will
decline. Thus, there is an inverse relationship between price and quantity demanded,
other things being same. The other things which are assumed to be equal or constant are the
prices of related commodities, income of consumers, tastes and preferences of consumers,
and such other factors which influence demand.

Demand Schedule: is a schedule which explains the relationship between price and quantity
demanded.
Demand Schedule of an Individual Consumer
Price Quantity demanded

(Rs.) (Units)

A 5 10
B 4 15
C 3 20
D 2 35
E 1 60

When price of commodity X is Rs.5 per unit, a consumer purchases 10 units of the commodity.
When the price falls to Rs.4, he purchases 15 units of the commodity. Similarly, when the price
further falls, quantity demanded by him goes on rising until at price Re.1, the quantity
demanded by him rises to 60 units. The above table depicts an inverse relationship between
price and quantity demanded.

Demand Curve: is a graphical representation of the Demand Schedule

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5 A

4 B

PRICE 3 C

D
2
E
1

0 X
10 20 30 40 50 60
QUANTITY

Market Demand Schedule: When we add up the various quantities demanded by the number
of consumers in the market we can obtain the market demand schedule.

Market Demand Schedule

Quantity demanded by
Price (Rs.) P Q R Total Market Demand
5 10 8 12 30
4 15 12 18 45
3 20 17 23 60
2 35 25 40 100
1 60 35 45 140

5
PRICE

15 30 45 60 75 90 105 120 135 150

QU ANTITY

Market Demand Curve

Market Demand Curve: If we plot market demand schedule on a graph we get market
demand curve. In other words, market demand curve is the horizontal summation of individual
demand curves.

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Rationale for the Law of Demand: (why does demand curve slopes downward to right)

1. Substitution Effect: When the price of a commodity falls, it becomes relatively cheaper
than other commodities. It induces 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 Effect: When the price of a 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 induces him to buy more of that commodity. Thus, demand for that commodity
(whose price has fallen) increases. This is called income effect.

3. Law of Diminishing Marginal Utility: This law states that as a consumer consumes more
and more units of a commodity, the additional utility derived from each additional unit goes
on diminishing. It means, the consumer will be willing to purchase an additional unit if it is
available at lower price than last unit. It is because a consumer always pays the price equal
to the MU of the commodity.

4. Number of Consumers: When the price of a commodity changes, the number of

consumers consuming the commodity in the market also changes. As a result the demand
behaves inversely to the change in price of the commodity. For example: if the price of the
commodity falls, the number of consumers in the market will increase. Hence the demand
will increase & vice versa.

5. Several Uses of Commodity: The commodity which has alternative uses such as
electricity, milk etc. are also one of the main causes of law of demand. For example: if the
price of electricity falls, its unnecessary uses will increase resulting the increase in its
demand & vice versa.

EXCEPTIONS OF LAW OF DEMAND

The following are the important exceptions to the law of demand:

(i) 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. 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.

(ii) Giffen goods: 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 of such goods are coarse grains like bajra, low quality of rice and wheat etc.

(iii) 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,

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cooking gas, etc. have been continuously rising, their demand does not show any
tendency to fall.
(iv) Future expectation about prices : It has been observed that when the prices 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.

(v) Rationality: The law has been derived assuming consumers to be rational and
knowledgeable about market-conditions. However, at times consumers tend to be
irrational and make impulsive purchases without any cool calculations about price and
usefulness of the product.

(vi) Ignorance effect: 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.

CHANGE IN QUANTITY DEMANDED

OR
EXPANSION AND CONTRACTION IN DEMAND
The demand schedule, demand curve and the law of demand all show that when the price of a
commodity falls its quantity demanded increases, other things being equal. When as a result of
decrease in price, the quantity demanded increases, in Economics, we say that there is an
expansion of demand and when as a result of increase in price, quantity demanded decreases
we say that there is contraction of demand. For example, suppose the price of apples at any
time is Rs.10 per kilogram and a consumer buys one kilogram at that price. Now, if other things
such as income, prices of other goods and tastes of the consumers remain same but the price
of apples falls to Rs.8 per kilogram and the consumer now buys two kilograms of apples, we
say that there is a change in quantity demanded or there is an expansion of demand. On the
contrary, if the price of apples raised to Rs.15 per kilogram and consumer buys only half a
kilogram, we say that there is a contraction of demand.
Y
D
II
P
PRICE

PI
D

L M N
QUANTITY

Expansion and Contraction in Demand

CHANGE IN DEMAND
OR
INCREASE AND DECREASE IN DEMAND

It should be noted that expansion and contraction in demand take place as a result of changes
in the price while all other determinants of price viz. income, tastes, propensity to consume and
price of related goods remain constant.

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Y Y
D2 D1
D1 D2

PRICE

PRICE
D2 D1
D1 D2
O X O X
Quantity Per Period of Time Quantity Per Period of Time

Rightward shift in the Leftward shift in the

demand Curve demand curve

(i) A rightward shift in the demand curve : (when more is demanded at same price) can be
caused by a rise in income, a rise in the price of a substitute, a fall in the price of a
complement, a change in tastes in favor of this commodity, an increase in population, and a
redistribution of income to group who favor this commodity.

(ii) A leftward shift in the demand curve : (when less is demanded at same price) can be
caused by a fall in income, a fall in the price of a substitute, a rise in the price of a
complement, a change in tastes against this commodity, a decrease in population, and a
redistribution of income away from groups who favor this commodity.

MOVEMENTS ALONG DEMAND CURVE Vs. SHIFT OF CURVE

A movement along the demand curve indicates changes in the quantity demanded
because of price changes, other factors remaining constant. A shift of the demand curve
indicates that there is a change in demand at each possible price because one or more other
factors, such as incomes, tastes or the price of some other goods, have changed.

Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift

of the whole curve because one or more of the factors which were assumed to remain constant
earlier have changed. When the economist speaks of change in quantity demanded he
means movement along the same curve (i.e. expansion or contraction of demand) which has
happened due to fall or rise in price of the commodity.

In short, ‘change in demand’ represents shift of the demand curve to right or left resulting
from changes in factors such as income, tastes, prices of other goods etc. and ‘change in
quantity demanded’ represents movement upwards or downwards on the same demand curve
resulting from a change in price of the commodity.

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