1.

Theory of Demand
1.1 Introduction
Demand theory evinces the relationship between the demand for goods and
services. Demand theory is the building block of the demand curve- a curve that establishes
a relationship between consumer demand and the amount of goods available. Demand is
shaped by the availability of goods, as the quantity of goods increases in the market the
demand and the equilibrium price for those goods decreases as a result.

Demand theory is one of the core theories of microeconomics and consumer

behaviour. It attempts at answering questions regarding the magnitude of demand for a
product or service based on its importance to human wants. It also attempts to assess how
demand is impacted by changes in prices and income levels and consumers
preferences/utility. Based on the perceived utility of goods and services to consumers,
companies are able to adjust the supply available and the prices charged.

In economics, demand has a specific meaning distinct from its ordinary usage. In
common language we treat ‘demand’ and ‘desire’ as synonymously. This is incongruent from
its use in economics. In economics, demand refers to effective demand which implies three
things:

• Desire for a commodity

• Sufficient money to purchase the commodity, rather the ability to pay

• Willingness to spend money to acquire that commodity

This substantiates that a want or a desire does not develop into a demand unless it is
supported by the ability and the willingness to acquire it. For instance, a person may desire
to own a scooter but unless he has the required amount of money with him and the
willingness to spend that amount on the purchase of a scooter, his desire shall not become a
demand. The following should also be noted about demand:

• Demand always alludes to demand at price. The term ‘demand’ has no meaning
unless it is related to price. For instance, the statement, 'the weekly demand for
potatoes in city X is 10,000 kilograms' has no meaning unless we specify the price at
which this quantity is demanded.

• Demand always implies demand per unit of time. Therefore, it is vital to specify the
 period for which the commodity is demanded. For instance, the statement that
demand for potatoes in city X at Rs. 8 per kilogram is 10,000 kilograms again has no
meaning, unless we state the period for which the quantity is being demanded. A
complete statement would therefore be as follows: 'The weekly demand for
potatoes in city X at Rs. 8 per kilogram is 10,000 kilograms'. It is necessary to specify
the period and the price because demand for a commodity will be different at
different prices of that commodity and for different periods of time. Thus, we can
define demand as follows:

“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”.

1.2 Theory of Demand

1.2.1 ESSENTIALS OF DEMAND

1. An Effective Need: Effective need entails that there should be a need supported by the
capacity and readiness to shell out. Hence, there are three basics of an effective need:

a. The individual should have a need to acquire a specific product.

b. He should have sufficient funds to pay for that product.

c. He should be willing to part with these resources for that commodity.

2. A Specific Price: A proclamation concerning the demand of a product without

mentioning its price is worthless. For example, to state that the demand of cars is 10,000
is worthless, unless expressed that the demand of cars is 10,000 at a price of Rs. 4,
00,000 each.

3. A Specific Time: Demand must be assigned specific time. For example, it is an

incomplete proclamation to state that the demand of air conditioners is 4,000 at the
price of Rs. 12,800 each. The statement should be altered to say that the demand of air
conditioners during summer is 4,000 at the price of Rs. 12,800 each.

4. A Specific Place: The demand must relate to a specific market as well. For example,
every year in the town of Dehradun, the demand for school bags is 4,000 at a price of Rs.
200.

Hence, the demand of a product is an effective need, which demonstrates the

quantity of a product that will be bought at a specific price in a specific market at some
 stage in a specific period. Nevertheless, the significance of a specific market or place is
not as significant as the price and time period for which demand is being measured.

1.2.2 LAW OF DEMAND

We have considered various factors that fashion the demand for a commodity. As
explained the first and the most important factor that determines the demand of a
commodity is its price. If all other factors (noted above) remain constant, it may be said that
as the price of a commodity increases, its demand decreases and as the price of a
commodity decreases its demand increases. This is a general behaviour observed in a
market. This gives us the law of demand:
“The demand for a commodity increases with a fall in its price and decreases with a rise in its
price, other things remaining the same”.
The law of demand thus merely states that the price and demand of a commodity are
inversely related, provided all other things remain unchanged or as economists put it ceteris
paribus.
• Assumptions of the Law of Demand

The above statement of the law of demand, demonstrates that that this law operates
only when all other things remain constant. These are then the assumptions of the law of
demand. We can state the assumptions of the law of demand as follows:

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 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 alter: Any alteration that takes place in the taste of the
consumers will in all probability thwart the working of the law of demand. It often
happens that when tastes or fashions change people revise their preferences. As a
consequence, the demand for the commodity which goes down the preference scale of
the consumers declines even though its price does not change.

3. Prices of other goods should remain constant: Changes in the prices of other goods
often impinge on 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 imperative 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 declines. This is quite natural, because with
the availability of new substitutes some buyers will be attracted towards new products
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 the
future.

6. Advertising expenditure should remain the same: If the advertising expenditure of a

firm increases, the consumers may be tempted to buy more of its product. Therefore,
the advertising expenditure on the good under consideration is taken to be constant.

Desire of a person to purchase a commodity is not his demand. He must possess

adequate resources and must be willing to spend his resources to buy the commodity.
Besides, the quantity demanded has always a reference to ‘a price’ and ‘a unity of time’. The
quantity demanded referred to ‘per unit of time’ makes it a flow concept. There may be
some problems in applying this flow concept to the demand for durable consumer goods like
house, car, refrigerators, etc. However, this apparent difficulty may be resolved by
considering the total service of a durable good is not consumed at one point of time and its
utility is not exhausted in a single use. The service of a durable good is consumed over time.
At a time, only a part of its service is consumed. Therefore, the demand for the services of
durable consumer goods may also be visualised as a demand per unit of time. However, this
problem does not arise when the concept of demand is applied to total demand for a
consumer durable. Thus, the demand for consumer goods also is a flow concept.

• Demand Schedule

The law of demand can be illustrated through a demand schedule. A demand

schedule is a series of quantities, which consumers would like to buy per unit of time at
different prices. To illustrate the law of demand, an imaginary demand schedule for tea is
given in Table 1.1. It shows seven alternative prices and the corresponding quantities
(number of cups of tea) demand per day. Each price has a unique quantity demanded,
associated with it. As the price per cup of tea decreases, daily demand for tea increases, in
accordance with the law of demand.
Table 1.1: Demand Schedule for Tea

Price per Cup of Tea (Rs.) No. of Cups of Tea Demand Symbols representing per
per Consumer per Day Price-Quantity Combination

8 2 A

7 3 B

6 4 C

5 5 D

4 6 E

3 7 F

2 8 G

• Demand Curve

The law of demand can also be presented through a curve called demand curve.
Demand curve is a locus of points showing various alterative price-quantity combinations. It
shows the quantities of a commodity that consumers or users would buy at difference prices
per unit of time under the assumptions of the law of demand. An individual demand curve
for tea as given in Fig. 1.1 can be obtained by plotting the data give in Table 1.1.
 In Fig. 1.1, the curve from point A to point G passing through points B, C, D and F is
the demand curve DD’. Each point on the demand curve DD’ shows a unique price-quantity
combination. The combinations read in alphabetical order should decreasing price of tea
and increasing number of cups of tea demanded per day. Price quantity combinations in
reverse order of alphabets illustrate increasing price of tea per cup and decreasing number
of cups of tea per day consumed by an individual. The whole demand curve shows a
functional relationship between the alternative price of a commodity and its corresponding
quantities, which a consumer would like to buy during a specific period of item—per day,
per week, per month, per season, or per year. The demand curve shows an inverse
relationship between price and quantity demanded. This inverse relationship between price
and quantity demanded results in the demand curve sloping downward to the right.

• Why does the demand curve slope downwards

As Fig. 1.1 shows, demand curve slopes downward to the right. The downward slope
of the demand curve reads the law of demand i.e. the quantity of a commodity demanded
per unit of time increases as its price falls and vice versa.

The reasons behind the law of demand i.e. inverse relationship between price and
quantity demanded are following:

Substitution Effect: When the price of a commodity falls it becomes relatively cheaper if
price of all other related goods, particularly of substitutes, remain constant. In other
words, substitute goods become relatively costlier. Since consumers substitute cheaper
goods for costlier ones, demand for the relatively cheaper commodity increases. The
increase in demand on account of this factor is known as substitution effect.

Income Effect: As a result of fall in the price of a commodity, the real income of its
consumer increase at least in terms of this commodity. In other words, his/her
purchasing power increases since he is required to pay less for the same quantity. The
increase in real income (or purchasing power) encourages demand for the commodity
with reduced price. The increase in demand on account of increase in real income is
known as income effect. It should however be noted that the income effect is negative in
case of inferior goods. In case, price of an inferior good accounting for a considerable
proportion of the total consumption expenditure falls substantially, consumers’ real
income increases: they become relatively richer. Consequently, they substitute the
superior good for the inferior ones, i.e., they reduce the consumption of inferior goods.
Thus, the income effect on the demand for inferior goods becomes negative.
 Diminishing Marginal Utility: Diminishing marginal utility as well is to be held
responsible for the rise in demand for a product when its price declines. When an
individual purchases a product, he swaps his money revenue with the product in order to
increase his satisfaction. He continues to purchase goods and services as long as the
marginal utility of money (MUm) is lesser than the marginal utility of the commodity
(MUC). Given the price of a commodity, he modifies his purchase so that MUC = MUm.
This plan works well under both Marshallian assumption of constant MUm as well as
Hicksian assumption of diminishing MUm. When price falls, (MUm = Pc) < MUC. Thus,
equilibrium state is upset. To get back his equilibrium state, i.e., MUm = PC, = MUC, he
buys more quantities of the commodity. For, when the supply of a commodity rises, its
MU falls and once again MUm = MUC. For this reason, demand for a product rises when
its price falls.

• Exceptions to the Law of Demand

The law of demand does not apply to the following cases:

Apprehensions about the future price: When consumers anticipate a constant rise in
the price of a long-lasting commodity, they purchase more of it despite the price rise.
They do so with the intention of avoiding the blow of still higher prices in the future.
Likewise, when consumers expect a substantial fall in the price in the future, they delay
their purchases and hold on for the price to decrease to the anticipated level instead of
purchasing the commodity as soon as its price decreases. These kinds of choices made by
the consumers are in contradiction of the law of demand.

Status goods: The law does not concern the commodities which function as a ‘status
symbol’, add to the social status or exhibit prosperity and opulence e.g. gold, precious
stones, rare paintings and antiques, etc. Rich people mostly purchase such goods as they
are very costly.

Giffen goods: An exception to this law is the typical case of Giffen goods named after Sir
Robert Giffen (1837-1910). 'Giffen goods' does not represent any particular commodity.
It could be any low-grade commodity which is cheap as compared to its superior
alternatives, consumed generally by the lower income group families as an important
consumer good. If price of such goods rises (price of its alternative remaining stable), its
demand escalates instead of falling. E.g. the minimum consumption of food grains by a
lower income group family per month is 30 kgs consisting of 20 kgs of bajra (a low-grade
good) at the rate of Rs 10 per kg and 10 kgs of wheat (a high quality good) at Rs. 20 per
kg. They have a fixed expenditure of Rs. 400 on these items. However, if the price of
 bajra rises to Rs. 12 per kg the family will be compelled to decrease the consumption of
wheat by 5 kgs and add to that of bajra by the same quantity so as to meet its minimum
consumption requisite within Rs. 400 per month. No doubt, the family's demand for
bajra rises from 20 to 25 kgs when its price rises.

• The Market Demand Curve

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 substitutes and complements, is known as individual 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, other things remaining the same, 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, per time unit and at a given price, other
factors remaining the same. For instance, suppose there are three consumers (viz., A, B, C)
of a commodity X and their individual demand at different prices is of X as given in Table 1.2.
The last column presents the market demand i.e. the aggregate of individual demand by
three consumers at different prices.

Table 1.2: Price and Quantity Demanded

Price of Quantity of X demanded by Market Demand

Commodity X
A B C
(Price per unit)

10 4 2 0 6

8 8 4 0 12

6 12 6 2 20

4 16 8 4 28

2 20 10 6 36

0 24 12 8 44

Graphically, market demand curve is the horizontal summation of individual demand

curves. The individual demand schedules plotted graphically and summed up horizontally
gives the market demand curve as shown in Fig. 1.2.
 The individual demands for commodity X are given by DA, D B and Dc, respectively. The
horizontal summation of these individual demand curves results into the market demand
curve (DM) for the commodity X. The curve DM represents the market demand curve for
commodity X when there are only three consumers of the commodity.

Fig. 1.2: Derivation of market demand

1.3 Demand Function

The functional relationship between the demand for a commodity and its various
determinants may be expressed mathematically in terms of a demand function, thus:

Dx = f (Px, Py, M, T, A, U) where,

Dx = Quantity demanded for commodity X.

f = functional relation.

Px = The price of commodity X.

Py = The price of substitutes and complementary goods.

M = The money income of the consumer.

T = The taste of the consumer.

A = The advertisement effects.

U = Unknown variables or influences.

The above-stated demand function is a complicated one. Again, factors like tastes
and unknown influences are not quantifiable. Economists, therefore, adopt a very simple
statement of demand function, assuming all other variables, except price, to be constant.
Thus, an over-simplified and the most commonly stated demand function is: Dx = f (Px),
which connotes that the demand for commodity X is the function of its price. The traditional
demand theory deals with this demand function specifically.

It must be noted that by demand function, economists mean the entire functional
relationship i.e. the whole range of price-quantity relationship and not just the quantity
demanded at a given price per unit of time. In other words, the statement, 'the quantity
demanded is a function of price' implies that for every price there is a corresponding
quantity demanded.

To put it differently, demand for a commodity means the entire demand schedule,
which shows the varying amounts of goods purchased at alternative prices at a given time.
Shift in Demand Curve

When demand curve changes its position retaining its shape (though not necessarily),
the change is known as shift in demand curve.

Fig 1.3: Shift in Demand Curves

Let’s suppose that the demand curve D2 in Fig. 1.3 is the original demand curve for
commodity X. As shown in the figure, at price OP2 consumer buys OQ2 units of X, other
factors remaining constant. If any of the other factors (e.g., consumer’s income) changes, it
will change the consumer’s ability and willingness to buy commodity X. For example, if
consumer’s disposable income decreases, say, due to increase in income tax, he may be able
to buy only OQ1 units of X instead of OQ2 at price OP2 (This is true for the whole range
of price of X) the consumers would be able to buy less of commodity X at all other prices.
This will cause a downward shift in demand curve from D2 to D1. Similarly, increase in
disposable income of the consumer due to reduction in taxes may cause an upward shift
from D2 to D3. Such changes in the position of the demand curve are known as shifts in
demand curve.

Reasons for Shift in Demand Curve

Shifts in a price-demand curve may take place owing to the change in one or more of
other determinants of demand. Consider, for example, the decrease in demand for
commodity X by Q1Q2 in Fig 1.3. Given the price OP1, the demand for X might have fallen
from OQ2 to OQ1 (i.e., by Q 1Q 2 ) for any of the following reasons:

• Fall in the consumer’s income so that he can buy only OQ1 of X at price OP 2—

it is income effect.

• Price of X’s substitute falls so that the consumers find it beneficial to substitute Q1Q 2 of X
 with its substitute—it is substitution effect.

• Advertisement made by the producer of the substitute, changes consumer’s taste or

preference against commodity X so much that they replace Q1Q2 of X with its substitute,
again a substitution effect.

• Price of complement of X increases so much that they can now afford only OQ X of X

• Also for such reasons as commodity X is going out of fashion; its quality has deteriorated;
consumer’s technology has so changed that only OQ1 of X can be used and due to
change in season if commodity X has only seasonal use.
1.4 Elasticity of Demand
While the law of demand establishes a relationship between price and quantity
demanded for a product, it does not tell us exactly as how strong or weak the relationship
happens to be. This relation, as already discussed, is inverse baring some rare exceptions.
However, a manager needs an exact measure of this relationship for appropriate business
decisions. Elasticity of demand is a measure, which comes to the rescue of a manager here.
It measures the responsiveness of demand to changes in prices as well as changes in income.
A manager can determine almost exactly how the demand for his product would change
when he changes his price or when his rivals alter prices of their products. He can also
determine how the demand for his product would change if incomes of his consumers go up
or down. Elasticity of demand concept and its measurements are therefore very important
tools of managerial decision making.

From decision-making point of view, however, the knowledge of only the nature of
relationships is not sufficient. What is more important is the extent of relationship or the
degree of responsiveness of demand to changes in its determinants. The responsiveness of
demand for a good to the change in its determinants is called the elasticity of demand. The
concept of elasticity of demand was introduced into the economic theory by Alfred Marshall.
The elasticity concept plays an important role in various business decisions and government
policies. In this unit, we will discuss the following kinds of demand elasticity.

• Price Elasticity: Elasticity of demand for a commodity with respect to change in its price.

• Cross Elasticity: Elasticity of demand for a commodity with respect to change in the price
of its substitutes.

• Income Elasticity: Elasticity of demand with respect to change in consumer’s income.

• Price Expectation Elasticity of Demand: Elasticity of demand with respect to consumer’s

expectations regarding future price of the commodity.

1.4.1 PRICE ELASTICITY OF DEMAND

The price elasticity of demand is delineated as the degree of responsiveness or
sensitiveness of demand for a commodity to the changes in its price. More precisely,
elasticity of demand is the percentage change in the quantity demanded of a commodity as
a result of a certain percentage change in its price. A formal definition of price elasticity of
demand (e) is given below:
 The measure of price elasticity (e) is called co-efficient of price elasticity. The
measure of price elasticity is converted into a more general formula for calculating
coefficient of price elasticity given as

-------------------------------------------eq. I

Where QO = original quantity demanded, PO = original price, ▲Q = change in quantity

demanded and ▲P = change in price.

Note that a minus sign (-) is generally inserted in the formula before the fraction with
a view to making elasticity coefficient a non-negative value.

1.4.2 POINT AND ARC ELASTICITY OF DEMAND

The elasticity of demand is conventionally measured either at a finite point or
between any two finite points, on the demand curve. The elasticity measured on a finite
point of a demand curve is called point elasticity and the elasticity measured between any
two finite points is called arc elasticity. Let us now look into the methods of measuring point
and arc elasticity and their relative usefulness.

(A) POINT E LASTICITY

The point elasticity of demand is defined as the proportionate change in quantity

demanded in response to a very small proportionate change in price. The concept of point
elasticity is useful where change in price and the consequent change in quantity demanded
are very small.

The point elasticity may be symbolically expressed as

---------------------------------------------eq.

II Measuring Point Elasticity on a Linear Demand Curve

 To illustrate the measurement of point elasticity of a linear demand curve, let us
suppose that a linear demand curve is given by MN in Fig. 1.4 and that we want to measure
elasticity at point P.

Fig. 1.4: Point Elasticity of a Linear Demand Curve

Let us now substitute the values from Fig. 1.4 in eq. II. As it is obvious from the
figure, P = PQ and Q = OQ. What we need now is to find the values for δQ and δP. These
values can be obtained by assuming a very small decrease in the price. However, it will be
difficult to depict these changes in the figure as and hence Q –O. There is however an easier
way to find the value for δQ/δP. In derivative given the slope of the demand curve MN. The
slope of demand curve MN, at point P is geometrically given by QN/PQ. That is, may be
proved as follows. If we draw a horizontal line from P and to the vertical -.here will be three
triangles.

Since at point P, P=PQ and Q=OQ, substituting these values in eq. II, (ignoring
the minus sign), we get

Geometrically,

▲MON, ▲MRP and ▲PQN (Fig. 3.1) in which ▲MON and ▲PQN are right angles.
Therefore, the other corresponding angles of the triangles will always be equal and hence,
▲ MON, ▲MRP and ▲PQN are similar triangles.
 According to geometrical properties of similar triangles, the ratio of any two sides of
similar triangle is always equal to the ratio of corresponding sides of the other sides.
Therefore, in ▲PQN and ▲MRP,

………………………………… eq. III

Hence, RP=OQ, by substituting OQ for RP in eq. III, we get

In proportionality rule, therefore,

It may thus be concluded that price elasticity at point P (Fig 1.4) is given by

Measuring Point Elasticity on a Non-linear Demand Curve

Let us now elucidate the method of measuring point elasticity on a non-linear

demand curve. Suppose we want to measure the elasticity of demand curve DD’ at point P
in, let us draw a line (MN) tangent to the demand curve DD’ at point P. Since demand curve
DD’ and the line MN pass through the same point (P) the slope of demand curve and that of
the line at this point is the same. Therefore, the elasticity of demand curve DD’ at point P
will be equal to the elasticity of demand line, MN, at point P. Elasticity of the line, MN, at
point P can be measured (ignoring ‘minus’ sign) as

Fig 1.5: Point Elasticity of Demand

 Given the graphical measurement of point elasticity, it is obvious that the elasticity at
a point of a demand curve is the ratio between the lower and the upper segments of a linear
demand curve from the point chosen for measuring point elasticity. That is,

Geometrically, QN/OQ=PN/PM. (For proof, see the proceeding section).

Fig 1.6: Point Elasticity on a non-linear Demand Curve

It follows that at mid-point of a linear demand curve, e = 1, as shown at point P in Fig.

1.6, because both lower and upper segments are equal (i.e., PN = PM) at any other point to
the left of point P, e > I and at any point to the right of point.

Price Elasticity at Terminal Points

The price elasticity at terminal point N equals 0 i.e. at point N, e = 0. At terminal

point M, however, price-elasticity is undefined, though most texts show that at terminal
point M, e = ∞. According to William J. Baumol, a Nobel Prize winner, price elasticity at
upper terminal point of the demand curve is undefined. It is undefined because measuring
elasticity at terminal point (M) involves division of zero and division by-zero is undefined. In
his own words, “Here the elasticity is not even defined because an attempt to evaluate the
fraction p/x at that point forces us to commit the sign of dividing by zero. The reader who
has forgotten why division by zero is immoral may recall that division is the reverse
operation of multiplication. Hence, in seeking the quotient c = a/b we look for a number, c,
which when multiplied by b gives us the number a, i.e., for which cb = a. But if a is not zero,
say a = 5 and b is zero, there is no such number because there is no c such that c x 0 = 5”.

(B) M EASURING ARC ELASTICITY

The concept of point elasticity is pertinent where change in price and the resulting
change in quantity are infinite or small. However, where change in price and the consequent
hunger in demand is substantial, the concept of arc elasticity is the relevant concept. Arc
elasticity is a measure of the average of responsiveness of the quantity demanded to a
substantial change in the price. In other words, the measure of price elasticity of demand
between two finite points on a demand curve is known as arc activity. For example, the
measure of elasticity between points J and K (Fig. 1.7) is: the measure of arc elasticity. The
movement from point J to K along the demand curve D) shows a fall in price from Rs 25 to Rs
10 so that AP = 25 - 10 = 15. The consequent increase in demand, AQ = 30 - 50 = - 20. The arc
elasticity between point J and K and (moving from J to K) can be obtained by substituting
these values in the elasticity formula.

………..eq. I

It means that a one percent decrease in price of commodity X results in a 1.11

percent increase in demand for it.

Fig 1.7: Measuring Arc Elasticity

Problems in Using Arc Elasticity

The use of arc elasticity in economic analysis entails a good deal of chariness because
it is capable of being misinterpreted. Arc elasticity coefficients differ between the same two
finite points on a demand curve if direction of change in price is reversed. Arc elasticity for a
decrease in price will be different from that for the same increase in price between the same
to points on a demand curve. For example, the price elasticity between points J and K —
moving from J to K — is equal to 1.11. This is the elasticity for decrease in price from Rs 25 to
Rs 10. But a reverse movement on the demand curve, i.e., from point K to J implies an
increase in price from Rs 10 to Rs 25 which will give a different elasticity coefficient. In case
of movement from point K to J, P = 10, ▲P = 10 - 25 = - 15, Q = 50 and ▲Q = 50 - 30 = 20.
Substituting these values in the elasticity formula, we get

The measure of arc elasticity co-efficient in equation I for the reverse movement in
price is obviously different from the one given in equation II. Therefore, while measuring the
arc elasticity, the direction of price change should be carefully noted, otherwise it may yield
misleading conclusions.

A method suggested to resolve this problem is to use the average of upper

and lower values of P and Q in fraction, P/Q, so that the formula is

Substituting the values from this example, we get

This method has its own drawbacks as the elasticity co-efficient calculated through
this formula, refers to the elasticity of demand at mid-point between points J and K (Fig.
1.7). Elasticity co-efficient (0.58) is not applicable for the whole range of price-quantity
combinations at different points between J and K on the demand curve (Fig. 1.7). It gives
only mean of the elasticity between the two points. It is important to note that elasticity
between the mid-point and the upper point J or lower point K will be different. Thus, this
method does not give one measure of elasticity.

1.4.3 NATURE OF DEMAND CURVES AND ELASTICITY

Generally, elasticity of a demand curve throughout its length is not the same (Fig.
1.8). It varies between 0 and ∞, or in other words,

In some cases, however, the elasticity remains the same throughout the length of the
demand curve. Such demand curves can be placed in the following categories: (i) perfectly
inelastic (e = 0); (ii) unitary elastic (e = 1); and (iii) perfectly elastic (e = ∞). These three types
of demand curves are illustrated in Fig. 1.8 (a), (b) and (c), respectively.

Fig 1.8: Constant Elasticity Demand Curve

1.4.4 SLOPE OF THE DEMAND CURVE AND PRICE ELASTICITY

The elasticity of a demand curve is often judged by its appearance: the flatter the
demand curve, the greater the elasticity and vice versa. But this conclusion is misleading
because two demand curves with different slopes may have the same elasticity at a given
price. In fact, what appearance of a demand curve reveals is its slope, not the elasticity. The
slope of the demand curve is the marginal relationship between change in price (▲P) and
change in quantity demanded (▲Q). The slope of demand curve is expressed as ▲P/▲Q. It
is the reciprocal of the slope ▲Q/▲P which appears in the elasticity formula, not the slope
itself.

We will show below: (i) that demand curves having different slopes may have the
same elasticity at a given price and (ii) that demand curves having the same slope may have
different elasticity at a given price.
 (A) ELASTICITY OF DEMAND CURVES HAVING DIFFERENT SLOPES

Let us first illustrate that two demand curves with different slops may have the same
elasticity at a given price. In Fig. 1.9, demand curves AB and AD have different slopes. It may
be proved as follows:

Fig 1.9: Demand Curves having different slopes

Slope of the demand curve AB=OA/OB and

Slope of the demand curve AD=OA/OD

Note that in these ratios, numerator OA is common to both the fractions, but in case
of denominators OB<OD.

Obviously, the slopes of the two demand curves are different. Let us now show, that
at a given price, both the demand curves have the same elasticity. As shown in Fig. at a given
price OP, the relevant points for measuring the elasticity are Q and R on the demand curves
AB and AD, respectively. Recall that the elasticity at a point on a linear demand curve is
obtained as
 Thus, at point Q on demand curve AB, ep=QB/QA and at point R on AD, ep=RD/RA

Thus, at point Q on demand curve AB, e = QB/QA and at point R on AD, ep = RD/RA. It
can be geometrically proved that the two elasticity are equal, i.e., QB=RD

Let us first consider ▲AOB. If we draw a horizontal line from point Q to intersect the
vertical axis at point P and an ordinate from Q to M at the horizontal axis, we have three
triangles— ▲AOB, ▲APQ and ▲QMB. Note that ▲AOB, ▲APQ and ▲QMB are right-
angles. Therefore, all the three triangles are right-angled triangles. As noted above, the
ratios of their two corresponding sides of similar right-angle triangles are always equal.
Considering only the relevant triangles, ▲APQ and ▲QMB, we have

Since MQ = OP, by substituting OP for QM in ratio BQ/MQ, we get

We can similarly prove that

Thus it is proved, that at price OP,

It is thus proved that two demand curves with different slopes have the same
elasticity at a given price.
 (B) ELASTICITY OF PARALLEL DEMAND CURVES

Fig 1.10: Price Elasticity of two parallel demand curves

Now, we will compare the price elasticity at two parallel demand curves at a given
price. This has been illustrated in Fig 1.10 where two demand curves AB and CD are given
which are parallel to each other. The two demand curves which are parallel to each other
imply that they have the same slope. Now, we can prove that at price OP price elasticity of
demand on the two demand curves AB and CD is different. Now, draw a perpendicular from
point R to the point P on Y-axis. Thus, at price OP the corresponding points on the two
demand curves are Q and R respectively.

The elasticity of demand on the demand curve AB at point Q will be equal to QB/QA
and at point R on the demand curve CD it is equal to RD/RC.

Because it is right-angled triangle OAB, PQ is parallel to QB:

Hence, price elasticity at point Q on the demand curve

At point R on the demand curve CD, price elasticity is equal to RD/RC. Because in the
right angled triangle OCD, PR is parallel to OD.

Hence, on point R on the demand curve CD, price elasticity =OP/PC

On seeing the diagram it will be clear that at point Q the price elasticity OP/PA and at
point R the price elasticity OP/PC are not equal to each other. Because PC is greater than PA,
 It is therefore; clear that at point R on the demand curve CD the price elasticity is less
than that at point Q on the demand curve AB, when the two demand curves being parallel to
each other have the same slope. It also follows that as the demand curve shifts to the right
the price elasticity of demand at a given price goes on declining. Thus, as has been just seen,
price elasticity at price OP on the demand curve CD is less than that on the demand curve
AB.

1.4.5 PRICE ELASTICITY AND MARGINAL REVENUE

In this section, we look at one of the most important uses of the price elasticity of
demand, used especially in business decision-making. It pertains to the relationship between
price elasticity and the marginal change in the total revenue of the firm planning to change
the price of its product. The relationship between price elasticity and the marginal revenue
(MR) can be derived as follows.

Let us suppose that a given output, Q, is being sold at a price P, so that the total
revenue, TR, equals P times Q, i.e.

TR = P X Q ……………….Eq. I

Since P and Q in eq. I are inversely related, a question arises, whether a change in P
will increase or decrease or leave the TR unaffected. It depends on whether MR is greater
than or less than or equal to zero, i.e., whether

MR > 0, MR < 0, or MR = 0

The marginal revenue, (MR) can be obtained by differentiating TR = PQ with respect

to P as shown below.
1. Price elasticity and total revenue

Given the relationship between marginal revenue and price elasticity of demand in
Eq. II, the decision-makers can easily know whether or not it is advantageous to change the
price. Given Eq. II, if e = 1, MR = 0. Therefore, change in price will not cause any change in
TR. If e < 1, MR < 0 and, therefore, TR decreases when price decreases and TR increases
when price increases. And, if e > 1, MR > 0, then TR increases if price decreases and TR
increases when price increases.

The effect of change in price on TR for different price-elasticity co-efficient is

summarised in the table mentioned below:

Table 1.3: Elasticity, Price change and change in TR

Elasticity Demand Nature of Price Change in TR Change in co-

efficient

ep = 0 Perfectly inelastic Increase Increases

Decrease Decreases
ep < 1 Inelastic Increase Increases

Decrease Decreases

ep = 1 Unitary elastic Increase No change in TR

Decrease

ep > 1 Elastic Increase Decrease

Decrease Increases

ep = ∞ Infinitely elastic Increase Decrease

Decrease to zero

Increase infinitely

As the table shows, when e = 0, the demand is said to be perfectly inelastic. Perfect
inelasticity of demand implies no change in quantity demanded when price is changed.
Therefore, a rise in price will increase the total revenue and vice versa. In case of an inelastic
demand (i.e., e < I), quantity demanded increases less than the proportionate decrease in
price and hence the total revenue falls when price falls. Total revenue increases when price
increases because quantity demanded decreases less than proportionately. If demand for a
product is unit-elastic (e = 1) quantity demanded increases (or decreases) in the proportion
of decrease (or increase) in the price. Therefore, the total revenue remains unaffected. If
demand for a commodity has e > 1, change in quantity demanded is greater than the
proportionate change in price. Therefore, the total revenue increases when price falls and
vice versa. The case of an infinitely elastic demand is rare. Such a demand line simply implies
that a consumer has the opportunity of buying any quantity of a commodity and the seller
can sell any quantity of the commodity, at a given price: it is the case of a commodity being
bought and sold in a perfectly competitive market.

1.4.6 PRICE ELASTICITY AND CONSUMPTION EXPENDITURE

Another important relationship which is often referred to in economic analysis is the
relationship between price elasticity and consumption expenditure. From the law of
demand, we know that quantity demanded of a commodity increases when its price falls.
But, what happens to the total expenditure on that commodity: does it fall or increase?

The relationship between price-elasticity and total consumption expenditure may be

derived as follows. Suppose that the total expenditure, Ex on a commodity X, at a given price,
P, all other prices remaining the same, is given by

EX = QX ∙ P X……………Eq. III

By differentiating Eq. III with respect to P X , we get marginal expenditure (ME), as

……………….. Eq. IV

The relationship between, total expenditure and price elasticity of demand has
summed up in the following table:

Table 1.4: Elasticity and Consumption Expenditure

Elasticity Price change Total Consumption

(ece)

ece > 1 Rise Decreases

Fall Increases
ece = 1 Rise Constant

Fall Constant

ece < 1 Rise Increases

Fall Decreases

As shown in Table 1.4, when ece > 1, e.g., demand is elastic, an increase in price
causes more than proportionate decrease in quantity demanded. Hence, total expenditure
decreases. And, if price decreases quantity demanded increases more than proportionately.
As a result, total expenditure increases.

When ece = 1, a rise (or fall) in price causes a proportionate fall (or rise) in quantity
demanded leaving total expenditure unchanged.

When ece < 1, i.e., when demand is inelastic, a rise in price causes a rise in the total
expenditure because demand decreases less than proportionately and a fall in price reduces
it as quantity demanded increases less than proportionately.

1.4.7 CROSS-ELASTICITY OF DEMAND

The cross-elasticity is the measure of responsiveness of demand for a commodity to
the changes in the price of its substitutes and complementary goods. For instance, cross-
elasticity of demand for tea (T) is the percentage change in its quantity demanded with
respect to the change in the price of its substitute, coffee (C). The formula for measuring
cross-elasticity of demand for tea (et,c) with respect to price of coffee (Pc)

The cross elasticity of demand for coffee (QC) with respect to price of tea (Pt)
is

………… Eq. V

For example, suppose that price of coffee (Pe) increases from Rs 10 to Rs 15, per 10
grams and as a result demand for tea increases from 20 tons to 30 tons per week, price of
tea remaining constant. By substituting these values in Eq. V, we get cross-elasticity of
demand for tea with respect to price of coffee, as

It is important to note that cross-elasticity between any two substitute goods is

always positive.

The same formula is used to calculate the cross-elasticity of demand for a good in
reaction to the change in the price of its complementary goods. Electricity to electrical
gadgets, petrol to automobile, butter to bread, sugar and milk to tea and coffee, are the
examples of complementary goods. Notice that the demand for complementary goods has
negative cross-elasticity e.g. rise in the price of a good reduces the demand for its
complementary goods.

A significant characteristic of cross-elasticity is that if cross-elasticity between two

goods is positive, the two may be regarded as substitutes for each other. Moreover, the
greater the cross-elasticity, the closer the substitute. Likewise, if cross-elasticity of demand
for two related goods is negative, the two may be regarded as complementary of each
other: the higher the negative cross-elasticity, the higher the degree of complementarily.

1.4.8 INCOME ELASTICITY OF DEMAND

Aside from the price of a product and its substitutes, another vital element of
demand for a product is consumer’s income. As noticed previously, the relationship
between demand for regular and luxury goods and consumer’s income is of positive nature,
not like the negative price-demand relationship. I.e, the demand for regular goods and
services rises with the rise in consumer’s income and vice versa. The reaction of demand to
the change in consumer’s income is known as income elasticity of demand.

Income elasticity of demand for a product, say X (i.e., ex ) is defined as

 Where X = quantity of X demanded; Y = disposable income; ▲X = change in quantity
demanded of X; and ▲Y = change in income.

Unlike price elasticity of demand (which is negative except in case of Giffen goods),
income elasticity of demand is positive because of a positive relationship between income
and demand for a product. There is an exception to this rule. Income elasticity of demand
for an inferior good is negative, because of negative income-effect. The demand for inferior
goods reduces with the rise in consumer’s income and vice versa. When income is more,
consumers change over to the consumption of superior commodities. I.e. they replace
inferior goods for superior ones. For instance, when income increases, people would rather
purchase more of rice and wheat and less of inferior food grains like bajara, ragi and use
more of taxi and less of bus service and so on.

NATURE OF COMMODITY AND INCOME ELASTICITY

For all regular goods, income elasticity is positive although the degree of elasticity
fluctuates as per the nature of commodities. Consumer goods are usually categorised under
three classes, viz. necessities (essential consumer goods), comforts and luxuries. The
universal structure of income elasticity for goods of various categories or a rise in income
and their effect on sales are provided in Table 1.5. The income elasticity of demand for
different categories of goods may still show discrepancies from house to house and from
time to time, as per the options, taste and preference of the consumers, degree of their
consumption and income and their receptiveness to ‘demonstration effect’. The other
aspect which could bring about a deviation from the universal structure of income elasticity
is the frequency of rise in income. Income rises often and repeatedly, income-elasticity as
provided in Table 1.5 follows the universal structure.

A few significant uses of income elasticity are as follows:

First, the concept of income elasticity can be used to approximately calculate the
potential demand only if the rate of rise in income and income elasticity of demand for the
commodities are identified. The information of income elasticity can hence be useful in
predicting demand, when changes in personal incomes are anticipated, other things
remaining the same.
Table 1.5: Income Elasticity of different consumer goods

Commodities Coefficient of income elasticity Impact on expenditure

Necessities Less than unitary (ey < 1) Less than proportionate change in
income

Comforts Almost equal to unity (ey = 1 ) Almost proportionate change in

income

Luxuries Greater than unity (ey > 1) More than proportionate increase in
income

Second, the concept of income elasticity could furthermore be used to describe the
‘regular’ and ‘inferior’ goods. The goods whose income elasticity is positive for all levels
of income are termed as ‘regular goods’. On the other hand, the goods for which
income elasticity is negative, further than a particular level of income, are termed as
‘inferior goods’
1.5 Determinants of Demand
Price elasticity of demand fluctuates from commodity to commodity. While the
demand of some commodities is highly elastic, the demand for others is highly inelastic. In
this section, we will describe the main determinants of the price elasticity of demand.

1. Availability of Substitutes

One of the most significant determinants of elasticity of demand for a commodity is

the availability of its substitutes. Closer the substitute, greater is the elasticity of demand for
the commodity. For instance, coffee and tea could be regarded as close substitutes for one
another. Thus, if price of one of these goods rises, its demand reduces more than the
proportionate rise in its price as consumers switch over to the relatively lower-priced
substitute. Moreover, broader the choice of the substitutes, greater is the elasticity. E.g.
soaps, washing powder, toothpastes, shampoos, etc. are available in several brands; each
brand is a close substitute for the other. Thus, the price-elasticity of demand for each brand
will be to a large extent greater than the general commodity. In contrast, sugar and salt do
not have their close substitute and for this reason their price-elasticity is lower.

1. Nature of Commodity

The nature of a commodity as well has an effect on the price elasticity of its demand.
Commodities can be categorised as luxuries, comforts and necessities, on the basis of their
nature. Demand for luxury goods (e.g., luxury cars, decorative items, etc.) are more elastic
than the demand for other types of goods as consumption of luxury goods can be set aside
or delayed when their prices increase. In contrast, consumption of essential goods, (e.g.,
sugar, clothes, vegetables, etc.) cannot be delayed and for this reason their demand is
inelastic. Demand for comforts is usually more elastic than that for necessities and less
elastic than the demand for luxuries. Commodities may also be categorised as durable goods
and perishable or non-durable goods. Demand for durable goods is more elastic than that
for non-durable goods, as when the prices of the former rises, people either get the old one
fixed rather than substituting it or buy ‘second hand’ goods.

3. Proportion of Income Spent on a Commodity

Another aspect that has an impact on the elasticity of demand for a commodity is the
proportion of income, which consumers use up on a specific commodity. If proportion of
income spent on a commodity is extremely little, its demand will be less elastic and vice
versa. Characteristic examples of such commodities are sugar, matches, books, washing
powder etc., which use a very tiny proportion of the consumer’s income. Demand for these
goods is usually inelastic as a rise in the price of such goods does not largely have an effect
on the consumer’s consumption pattern and the overall purchasing power. Thus, people
continue to buy approximately the same quantity even at the time their price rises.

4. Time Factor

Price-elasticity of demand relies moreover on the time which consumers take to

amend to a new price: longer the time taken, greater is the elasticity. As each year passes,
consumers are capable of altering their spending pattern to price changes. For instance, if
the price of bikes falls, demand may not rise instantaneously unless people acquire surplus
buying capacity. In the end nevertheless people can alter their spending pattern so that they
can purchase a car at a (new) lower price.

5. Range of Alternative Uses of a Commodity

Broader the range of alternative uses of a commodity, higher the price elasticity of its
demand intended for the fall in price however less elastic for the increase in price. As the
price of a versatile commodity falls, people broaden their consumption to its other uses.
Thus, the demand for such a commodity usually rises more than the proportionate fall in its
price. E.g., milk can be consumed as it is, it could be transformed into curd, cheese, ghee and
buttermilk. The demand for milk will thus be extremely elastic for fall in their price. Likewise,
electricity can be utilised for lighting, cooking, heating, as well as for industrial purposes.
Thus, demand for electricity is extremely price elastic for fall in its price. For this reason,
nevertheless, demand for such goods is inelastic for the increase in their price.

6. The Proportion of Market Supplied

Price elasticity of market demand furthermore relies on the proportion of the market
supplied at the determined price. If less than half of the market is supplied at the
determined price, elasticity of demand will be higher if more than half of the market is
supplied. i.e. demand curve is more elastic at the upper half than at the lower half.
1.7 Summary
Demand: "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”.

Law of Demand: “The demand for a commodity increases with a fall in its price and
decreases with a rise in its price, other things remaining the same”. The Law of demand thus
merely states that the price and demand of a commodity are inversely related, provided all
other things remain unchanged or as economists put it ceteris paribus.

Assumptions to the Law of Demand: We can state the assumptions of the law of
demand as follows: (1) Income level should remain constant, (2) Tastes of the buyer should
not change, (3) Prices of other goods should remain constant, (4) No new substitutes for the
commodity, (5) Price rise in future should not be expected and (6) Advertising expenditure
should remain the same.

Why Demand Curve Slopes Downwards: The reasons behind the law of demand, i.e.,
inverse relationship between price and quantity demanded are following: (i) substitution
effect, (ii) income effect, (iii) diminishing marginal utility.

Market Demand: The total quantity which all the consumers of a commodity are
willing to buy at a given price per time unit, other things remaining the same, 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, per time
unit and at a given price, other factors remaining the same.

Individual demand: The individual demand means the quantity of a product that an
individual can buy given its price. It implies that the individual has the ability and willingness
to pay.

Demand Function: Demand function is a mathematical expression of the law of

demand in quantitative terms. A demand function may produce a linear or curvilinear
demand curve depending on the nature of relationship between the price and quantity
demanded. The functional relationship between the demand for a commodity and its
various determinants may be expressed mathematically as:

Dx = f (Px, Py, M, T, A, U) where, Dx = Quantity demanded for commodity X, f =

functional relation, Px = The price of commodity X, Py = The price of substitutes and
complementary goods, M = The money income of the consumer, T = The taste of the
consumer, A = The advertisement effects, U = Unknown variables or influences

Elasticity of Demand: The concept of elasticity of demand can be defined as the

degree of responsiveness of demand to given change in price of the commodity.

Methods of Measurement of Elasticity of Demand: By using three different

methods, elasticity of demand is measured.

• Ratio Method

• Expenditure Method

• Point Method