CHAPTER – TWO: DEMAND ANALYSIS
Meaning of Demand:
Demand is such a human desire which is backed by ability to pay and willingness to pay fort goods and services
at a particular point of time or duration of time. If some one just dreams but lacks the ability and willingness to
pay, it can not be demand. It is simply a desire. For an instance, if a layman wants to buy a building in city, it is
mere desire but if a multimillionaire business man wants to buy a building, it could be demand.
Features of Demand:
The fundamental features of demand are as follows:
1. Demand depends upon utility of goods and services.
2. Demand always refers to the effective demand ( demand followed by desire, ability to pay and
willingness to pay)
3. Demand is a flow concept which is defined at a particular point of time or duration of time.
4. Demand refers just to the demand for final goods.
5. Demand is a desired quantity of something which must show consumer’s need to buy.
Kinds of Demand
Demand may be broadly classified into four kinds. They are briefly explained below.
1.
Direct Demand
Direct demand refers to the demand for a commodity which is directly consumed by individuals,
households and institutions to get satisfaction. For example, demand for fruits, foods or clothes by
an individual are examples of direct demand. Direct demand can be further classified into three
types. They are as follows.
a) Price Demand
If various units of quantity demanded of a commodity by a consumer or a household is
influenced not by other determinants of demand but by price of the commodity itself, other
things remaining the same, it is defined as price demand. The norm of price demand exists if
there is no change in determinants of demand other than price of the commodity. Price demand
shows inverse or opposite relationship between price and quantity demanded of goods and
services in a market. The following diagram shows nature of price demand.
FIGURE
1.1
Price
demand
curve
Y
Diagrammatic Representation
D
Price
P3
P2
P1
D1
O
Q1
Q2
Q3
X
Quantity Demanded
1
Figure 1.1 is related to price demand in which price and quantity demanded are measured
along ‘Y’ axis and ‘X’ axis respectively. In the beginning a consumer is prepared to demand
‘OQ1’ quantity of a commodity at price ‘OP3’. When the price of the commodity falls from
‘OP3’ to ‘OP2’ to ‘OP1’ the consumer would be able to demand more units of the commodity
from ‘OQ1’ to ‘OQ2’ to ‘OQ3’ respectively. The downward slopping demand curve DD1 shows
inverse relationship between price and quantity demanded of a commodity.
b) Income Demand
If various units of quantity demanded of a commodity by a consumer or a household are
influenced not by other factors but by income of consumers, other things remaining the same, it
is defined as income demand. The norms of income demand exist if there is no change in
determinants of demand other than income of the consumer. Income Demand can be analyzed
under two conditions. They are briefly described below.
i) Demand for Superior Goods
If quantity demanded for a commodity increases along with increase in income of the
consumer or a household, it is defined as income demand for superior goods. Demand for
motorcycle in place of cycle, demand for computer in place of type writer, demand for gas
stove in place of kerosene stove or fire-wood are some examples of demand for superior
goods. Income demand for superior goods shows direct relationship between income of
consumer and quantity demanded for such commodities in a market. The following
diagram shows the nature of income demand for superior goods.
Diagrammatic Representation
Y
D1
Y3
Income
FIGURE
1.2
Income
demand for
superior
goods
Y2
Y1
O
D
Q1
Q2
Q3
X
Quantity Demanded
Fig. 1.2 shows income demand for superior goods in which income and quantity demanded
are measured along ‘Y’ axis and ‘X’ axis respectively. If income of a consumer increases
from ‘OY1’ to ‘OY2 ‘to ‘OY3’ the quantity demanded for the commodity will increase from
‘OQ1 to ‘OQ2’ to ‘OQ3,’ respectively and vice versa. The upward slopping demand curve
DD1 shows direct relationship between income and quantity demanded for superior goods.
ii) Demand for Inferior Goods
If quantity demanded for a commodity decreases along with increase in income of a
consumer or a household, it is defined as income demand for inferior goods. Demand for
cycle in place of motorcycle, demand for type writer in place of computer, demand for
kerosene stove or fire-wood in place of gas stove are some examples of demand for inferior
goods. Income demand for inferior goods shows inverse relationship between income of
consumer and quantity demand for a commodity in a market. The following diagram shows
nature of income demand for inferior goods.
2
Diagrammatic Representation
Y
D
Y3
Income
FIGURE
1.3
Income
demand for
inferior
goods
Y2
Y1
D1
O
Q1
Q2
X
Q3
Quantity Demanded
Fig 1.3 shows income demand for inferior goods in which income and quantity demanded
are measured along ‘Y’ axis and ‘X’ axis respectively. If income of a consumer falls from
‘OY3’ to ‘OY2 ‘to ‘OY1’ the quantity demand for the commodity will increase from ‘OQ1
to ‘OQ2’ to ‘OQ3’ respectively and vice versa. The downward slopping demand curve
(DD1) shows inverse relationship between income and quantity demanded for inferior
goods.
c) Cross Demand
If the quantity demanded of a commodity in a market at a particular point of time is influenced
not by other factors but by the price of complement and substitute commodity, it is defined as
cross demand. The case of cross demand can be analyzed under two conditions. They are
briefly described below.
i) Demand for Substitute Goods
In case of substitute goods, if the price of a commodity falls, quantity demand for substitute
commodity will decrease consequently and vice versa. For example, the two products,
Pepsi and Coke are supposed to be substitutes to each other. When the price of Pepsi falls
(price of Coke remaining the same), it becomes relatively cheaper than Coke. As a result
the quantity demand for Pepsi will increase. But on the other side, the quantity demand for
Coke will decrease consequently and vice versa. The following diagram shows the nature
of demand for substitute goods.
Diagrammatic Representation
Y
D1
Price of Pepsi
FIGURE
1.4
Demand
curve for
substitute
goods
P3
P2
P1
O
D
Q1
Q2
Q3
X
Quantity Demanded for Coke
Fig 1.4 shows demand for substitute goods where price of Pepsi and quantity demanded
of Coke are measured along ‘Y’ axis and ‘X’ axis respectively. As the price of Pepsi falls
from ‘OP3’ to ‘OP2’ to ‘OP1’ it becomes relatively cheaper than Coke. As a result the
quantity demanded of Coke decreases from ‘OQ3’ to ‘OQ2’ to ‘OQ1’ respectively. The
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upward slopping demand curve DD1 shows the direct relationship between the price and
quantity demanded of substitute goods.
ii) Demand for Complement Goods
In case of complement goods, if the price of a commodity falls quantity demand for
complement goods will increase consequently and vice versa. For example, the two goods,
sugar and sweets are supposed to be complement to each other. When the price of sugar
falls, the price of sweets also falls. As a result, the quantity demand for sweets will increase
consequently. In this case, every increase in quantity demand for sweets is effect of change
in price of sugar. On the other side, as the price of sugar rises, the price of sweets also rises.
As a result, the quantity demand for sweets will decrease consequently. The following
diagram shows the nature of demand for complement goods.
Y
Diagrammatic Representation
D
Price of Sugar
Figure 1.5
Demand
curve for
complement
goods
P3
P2
P1
D1
O
Q1
Q2
Q3
X
Quantity Demanded for Sweets
2.
3.
In the Fig 1.5 price of sugar and quantity demanded for sweets are measured along ‘Y’
axis and ‘X’ axis respectively. If the price of sugar falls, from ‘OP3 to ‘OP2’ to ‘OP1, the
price of sweets will also fall consequently. As a result, the quantity demanded for sweets
will increase from ‘OQ1’ to ‘OQ2’ to ‘OQ3’ respectively. The downward slopping demand
curve DD1 shows the inverse relationship between the price and quantity demanded of
complement goods. The demand for complement goods is often known as joint demand.
Indirect Demand
It is also known as derived demand. Demand for various intermediate/interrelated items such as
labor, raw materials, energy which are most essential to make a final product is defined as derived
demand.
Some examples of direct and indirect demand are listed below.
S.N.
Direct Demand
Derived Demand
1. Demand for a cup of tea
demand for water, sugar, milk, tea, energy,
labour, utensils etc.
2. Demand for motorbike
demand for money, license, petrol, Mobil,
helmet etc.
3. Demand for school
demand for teacher, student, stationary,
building, land etc.
Joint Demand
Quantity demanded of several goods by a consumer or a household to fulfill their single purpose is
known as joint demand. It is based on quantity demand of complement goods. It is the case in
which every change in price of one commodity brings about substantial change in quantity demand
for complement goods. Some examples of joint demand are listed below.
a) Demand for water, sugar, milk and tea to make a cup of tea,
b) Demand for pen, ink and a paper to write something,
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4.
c) Demand for helmet, petrol, engine oil to run motorcycle.
Composite Demand
Demand for a commodity, which can be used for several purposes or uses, is defined as composite
demand. For example, demand for coal, which can be used for heating, cooking, running steam
engines etc. Like wise demand for electricity, potato, cloths etc are additional examples of this type.
Demand for those commodities increases when their prices fall and vice versa.
LAW OF DEMAND
Law of demand is one of the fundamental theories of microeconomics. The Neo-classical economist, Alfred
Marshall, propounded this law in the book Principle of Economics in the1890. It is based on the functional
(opposite or negative or inverse) relationship between price and quantity demanded of goods and services.
Regarding the definition of the law, several opinions are developed among the economists. Some logical and
scientific definitions of the law are as follows:
According to Alfred Marshal, “Other things remaining the same, when the price of a commodity falls,
quantity demanded for the commodity will increase and on the contrary, as the price of the commodity rises,
the quantity demanded for the commodity will decrease”. In other words, the law of demand states that when
the price of a commodity rises, its quantity demanded will decrease and if the price of a commodity falls, its
quantity demanded will increase. There exists an inverse relationship between price and quantity demanded of
goods and services.
Demand function:
The law of demand can be expressed in demand function which is as follows.
DA = f (PA), ceteris paribus
Where, D = Demand for a commodity
P = Price for a commodity
F = functional relationship between demand and price for a commodity
It indicates that when the price of a commodity rises, quantity demanded decreases and vice versa, other things
remaining the same.
Assumptions:
The law of demand is based on following assumptions:
1.
Income of the consumer should be fixed,
2.
Consumer's tastes and preferences shouldn't change,
3.
Price of complement goods should remain same,
4.
Price of substitute goods should remain same,
5.
Advertisement of goods and services should not change,
6.
State of technology should not change,
7.
Number of consumers should not change.
The law of demand can be explained by the help of demand schedule and demand curve which have been given
below.
Demand Schedule
Demand schedule is a tabular presentation of various units of price and quantity demanded for a particular
commodity by a consumer or a household at a particular unit of time or duration of time, other things remaining
the same. A sample of demand schedule has been presented below:
5
Demand Schedule
Price
of
a Quantity Demanded
Commodity
of
a
(Rs./Kg/)
Commodity (In Kg.)
50
10
40
20
30
30
20
40
10
50
This schedule is related to the price of a commodity and its quantity demanded by a consumer in a market at a
particular unit of time or duration of time. In the beginning, quantity demand is Rs. 10 kg at Rs. 50 per kg. As
the price falls from Rs. 50 to Rs. 40 to Rs. 30 to Rs. 20 to Rs. 10, the quantity demand for the commodity
increases from 10 kg to 20 kg to 30 kg to 40 kg to 50 kg respectively. The table has shown inverse or negative
relationship between price and quantity demanded that is, at higher price less quantity is demanded and at lower
price more quantity is demanded.
Demand Curve
Demand curve is a graphical representation of various units of price and quantity demanded for a particular
commodity by a consumer or a household at a particular unit of time or duration of time, other things remaining
the same. It also shows negative or inverse relation between price and quantity demanded of commodity.
Y
Diagrammatic Representation
D
Price
P3
P2
P1
O
D1
Q1
Q2
Q3
Quantity Demanded
Fig : Demand Curve
X
This figure is related to derivation of demand curve where price and quantity demanded are measured along
‘Y’- axis and ‘X’- axis respectively. The normal demand curve is denoted by DD1, which is slopping downward
from left to the right. When the price of a commodity is OP3 , quantity demanded is OQ1. As price falls from
OP3 to OP2 to OP1, the quantity demanded increases fro OQ1 to OQ2 to OQ3 respectively. It shows that higher
the price lower the quantity demanded and lower the price higher the quantity demanded. The slope of demand
curve is negative. It normally slopes from left to the right showing inverse relationship between price and
quantity demanded.
Reasons behind Downward Slopping Demand Curve
According to the law of demand, quantity demanded for a commodity increases when the price of the
commodity falls. As a result, a normal demand curve slopes downward from left to right under following
conditions:
1. Law of Diminishing Marginal Utility: A normal demand curve is derived from the curve of law of
diminishing marginal utility. The law of diminishing marginal utility suggests that when a consumer
consumes more and more unit of a commodity, the marginal utility will decline from the additional units
of consumption of the commodity. Therefore, consumers will demand more units of commodity only
when the price of the commodity falls along with fall in marginal utility derived from it. As we represent
this relation in diagram, the utility curve slopes downwards from left to the right being similar to the
shape of normal demand curve.
2. Increase in Real Income: Real income refers to the amount saved due to the fall in price of a
commodity while purchasing the commodity by a consumer. When the price of a commodity falls, the
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real income and the purchasing power of the consumer increases. As a result, consumers would be able to
purchase more unit of commodity at lower price from the given amount of his budget. In another sense,
as the price of a commodity falls, consumer will have some amount of surplus money to buy more units
of the commodity which results more demand for the commodity. When we represent this type of relation
in graph, we can get downward slopping demand curve.
3. Substitution Effect: When the price of a commodity falls, it becomes relatively cheaper than its
substitute goods. As a result consumers will prefer to buy more units of cheaper commodity instead of
expensive one. As a result, the quantity demanded for cheaper commodity increases along with fall in
price level. For an example, when the price of Coke falls (price of Pepsi remaining the same), the
quantity demand for coke increases. If we represent this relation in graph, we will derive downward
slopping demand curve.
4. Entry of New Consumers: When the price of a commodity falls, many new consumers of low
purchasing power will be able to demand that commodity in the market. They can buy more and more
quantity of that commodity at lower price. Due to this reason, demand for the commodity increases at
lower price. As we represent this relation in graph the demand curve can be obtained.
5. Composite Demand: When the price of goods of several uses falls, the quantity demands for those
goods rises and vice versa. For example demand for coal, potato, cloths are composite demand. Once we
represent this relation in graph, the downward slopping demand curve may be derived.
Exceptions or Limitations to the Law of Demand
The law of demand is not far from its limitations because it is derived from many hypothetical assumptions.
There are several limitations or exceptions to this law, which are briefly explained below:
1. Demand for Prestigious Goods (Veblen Goods): Some rich consumers measure the utility or worth or
value of goods and services in terms of price level. If the price of prestigious goods falls, rich consumers
regard them as inferior goods. As a result, quantity demanded of such goods decreases despite fall in price
level. On the contrary, as the price of such goods rises, they regard such goods as superior. As a result, the
quantity demanded for such goods increases despite rise in price, which is against the law of demand.
2. Price Expectation: If the consumers expect that the price of a commodity will fall further more in near future,
they will not buy any more quantity of the commodity, even if the price is lower. On the contrary, as the
consumers expect further rise in price of a commodity, they will buy more unit of that commodity even if the
price is higher, which is also against the law of demand.
3. Fear of Shortage: If the consumers fell that some commodities are going to be scare in the market in near
future, they will buy more and more unit of such commodities, even if the price is rising, which also
contradicts the law of demand.
4 Income Effect: Level of income also affects the quantity demanded of a commodity. If the consumer's
income increases, they will demand more units of goods and services despite the rise in price level. On the
other hand, if the consumer's income falls, they will have few amounts with them to buy and their
purchasing power will fall as well. As a result, they can demand less quantity of goods and services despite
fall in price level which also contradicts the norm of law of demand.
5. Goods of Basic Needs: The demand for some basic goods such as salt, rice kerosene matches do not
change despite rise or fall in price level. It is because consumers must consume such goods at any cost to
sustain their life. The law of demand, once again, fails in this regard.
6. Giffen Goods: The concept of Giffen goods was introduced by Sir Robert Giffen. Giffen goods refer to the
inferior but most essential goods to low income class consumers. It is demanded by low –paid wage earning
consumers. They have to spend large percentage of their total income in basic things. As the price of Giffen
goods rises, low paid wage earners have to allocate their major share of budget to buy such goods because
they cannot afford for other alternative goods. As a result, demand for those goods rises despite rise in
price.
7
Some additional limitations of the law are:
7.
The law does not apply during the celebration of ritual and traditional functions
8.
The law does not apply if there is change in marketing strategy of a product.
9.
The law does not apply to the newly introduced brand in production.
10.
The law does not apply to the change in season.
CHANGE IN DEMAND
Demand for any types of goods and services do not remain constant over long period. It changes along with
change in price and other determinates of demand. The change in quantity demanded can be analyzed in two
ways. They are movement along the demand curve and shift in demand curve, both of which are briefly
explained below:
Movement along the Demand Curve (Extension or Contraction)
Movement along the demand curve is completely based on the norms of law of demand. The law of demand
concludes that, other things remaining same, if the price of a commodity falls, quantity demanded for that
commodity will rise and vice versa.
Movement along the demand curve can be defined as the state of increase or decrease in quantity
demand due to the fall and rise in price level of a commodity assuming all other determinants of demand (or
non- price factors) remaining the constant. The state of increase and decrease in demand is often known as
extension and contraction in demand.
Change in equilibrium point up and down (from one point to other) along the same demand curve, due to
the change in price, other determinants of demand remaining the same, is defined as movement along the
demand curve.
According to David Begs, “Movement along the demand curve represents consumer adjustment to the
change in market price”. The movement along the demand curve takes place only when the following
determinants of demand (non – price factors) remain the same:
 Income of consumers,
 Taste and preference of consumers,
 Price of substitute goods,
 Price of complement goods,
 Advertisement,
 Number of consumers,
 State of technology,
 Climate and temperature etc.
The following diagram shows movement along demand curve.
Y
Diagrammatic Representation
D
P2
E2
Price
Contraction in Demand
P
P1
E
E1
Extension in Demand
D1
O
Q2
Q
Q1
Quantity Demanded
Fig : Movement Along Demand Curve
X
8
Fig. shows movement along demand curve in which price and quantity demanded are measured in ‘Y’ and ‘X’
axes respectively. The demand curve is denoted by 'DD1' which has been slopping downwards from left to the
right. The market equilibrium point is represented by point 'E' where equilibrium price and quantity are ‘OP’
and ‘OQ’ Respectively. When the price of the commodity falls from ‘OP’ to ‘OP1’, the quantity demanded for
the commodity increases from ‘OQ’ to ‘OQ1’. Then the equilibrium point moves from point ‘E’ to point ‘E1’,
which is called extension in quantity demanded.
On the other hand, as the price rises form ‘OP’ to ‘OP2’, the quantity demanded for the commodity decreases
from ‘OQ’ to ‘OQ2’. As a result, the market equilibrium point moves from point ‘E’ to point ‘E2’, which is
defined as contraction in quantity demanded.
The movement of equilibrium from point ‘E’ to ‘E1’ and ‘E’ to ‘E2’ jointly due to change in market price, other
determinants of demand (non price factor) remaining the same, is defined as the movement along the demand
curve.
Shift in Demand Curve
If the normal demand curve shifts upward (towards right) and downward (towards left) from its normal position
due to the determinants of demand (non – price factors) other than price of the commodity, it is defined as shift
in demand curve. The determinants of demand or non – price factors are tastes and preferences of the consumer,
income of the consumer, price of substitute and complement goods, advertisement, number of consumers etc.
Shift in demand curve is also known as increase or decrease in quantity demanded.
1. Increase in Demand: The state of upward shift (towards right) of demand curve from normal demand curve,
due to the change in other determinants of demand (non– price factors) beside price of a commodity is defined
as increase in demand. Increase in demand means more unit of quantity demanded at constant price.
2. Decrease in Demand: The state of downward shift (towards left) of demand curve from normal demand
curve due to the change in other determinants of demand beside price is called decrease in demand. Decrease
in demand means less unit of quantity demanded at constant price.
Factors that increase and decrease in demand
S.N.
1
2
3
4
5
6
Increase in demand (Upward and Decrease in demand (downward and leftward
rightward shift in demand)
shift in demand)
Increase in consumer's income,
Decrease in consumer's income,
Increase in tastes and preferences
Fall in tastes and preferences of a
of a commodity,
commodity,
Increase in price of substitute
goods,
Decrease in price of complement
goods
Increase in size of population
(number of consumers),
Application of modern technology
in production.
Decrease in price of substitute goods,
Increase in price of complement goods,
Decrease in size of population (number of
consumers),
Application of old technology in
production.
9
The following diagram shows increase and decrease quantity demanded.
Y
Diagrammatic Representation
D1
D
Decrease in Demand
Increase in Demand
D2
E2
E
E1
Price
P
D1
D
D2
O
Q2
Q
Q1
Quantity Demanded
Fig : Shift in Demand Curve
X
The Fig shows derivation of shift in demand curve in which price and quantity demanded are measured
along ‘Y’ axis and ‘X’ axis respectively. The normal demand curve is represented by ‘DD’ which is
slopping downwards from left to the right. The market equilibrium point is denoted by point ‘E’ where
equilibrium price and quantity are ‘OP’ and ‘OQ’ respectively. When there is increase in demand due to
determinants of demand, the demand curve ‘DD’ shifts upward (towards right) to ‘D1D1’. As a result, the
equilibrium point shifts from ‘E’ to ‘E1’ and the quantity demand increases from ‘OQ’ to ‘OQ1’
consequently. The change in equilibrium from point ‘E’ to ‘E1’ is defined as increase in demand.
On the other hand, when there is decrease in demand due to determinants of demand, the normal demand
curve ‘DD’ shifts downwards (towards left) to ‘D2D2’. As a result, the equilibrium point shifts from ‘E’ to
‘E2’ and the quantity demand decreases from ‘OQ’ to ‘OQ2’consequently. Change in equilibrium from
point ‘E’ to ‘E2’ is defined as decrease in quantity demand.
Change in equilibrium from point ‘E’ to ‘E1’ and ‘E’ to ‘E2’ as well as shift in demand curve from DD to
D1D1 and D2D2 jointly is defined as shift in demand curve.
Factors Causing the Shift in Demand Curve
Shift in demand curve is the effect of change in quantity demanded of goods and services due to non – price
factors. The factors that bring changes in quantity demanded, other than price are briefly explained below:
1. Price of Related Goods: The term 'price of related goods' refers to the price of substitute goods and
complement goods. Those goods are said to be substitute if the fall in price of one good result more quantity
demand of that good and less quantity demand for substitute goods. For an example Pepsi and Coke are
substitute goods. When the price of Pepsi falls the quantity demanded of it increases and the quantity
demand for Coke decreases and vice - versa. There is direct relationship, between the price and quantity
demanded of substitute goods.
Those goods are said to be complement if the fall in price of one commodity results more quantity demand
for other commodity. For a example sugar and sweet are complement goods. When the price of sugar falls,
the price of sweet also falls. As a result the quantity demand for sweets increases and vice - versa. There is
inverse relationship, between the price and quantity demanded of complement goods.
2. Consumer's Income: The demand for a commodity changes along with change in consumer's income. If
the demand increases with the increase in income, such goods are defined as normal goods. On the contrary,
if the demand decreases with the increase income, such goods are defined as inferior goods. The demand
curve shifts towards right from the normal demand curve in case of normal goods and it shifts towards left
from the normal demand curve incase of inferior goods.
3. Changes in Tastes and Preferences of Consumers: When fashionable goods move out from the market,
the quantity demand of such goods will be less despite fall in price level. The demand curve, in this regard
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4.
5.
6.
7.
shifts towards left from the normal position curve. On the contrary, if the fashion for particular good
increases, the demand curve shifts rightward despite rise or constancy in price level.
Technological Progress: Technological progress means innovation of new techniques in production, which
helps to reduce price and ensures better quality in production. For example, supply of electricity has
replaced use of kerosene lamp and introduction of mobile phone has reduced the scope of cable telephone.
The demand for modern product increases along with introduction of new technology in the society. As a
result the normal demand curve shifts toward right. On the contrary, if the state of technology lies out of the
model, goods produced from such technology decreases. As a result, demand curve may shifts towards left
from normal demand curve.
Change in Size of Consumer: Increase or decrease in number of consumers brings substantial change in
quantity demand. As the number of consumer in the market increases, quantity demand for goods and
services also increases. As a result normal demand curve shifts towards right. On the other hand, if the
number of consumer decreases, the quantity demand for goods and services also decreases consequently. As
a result, the normal demand curve shifts towards left from the normal position. Acute shortage of water
supply in Kathmandu valley and rapid rise in price of basic goods are ample examples of increase in
demand due to the increase in number of consumers.
Change in Money Supply: If the quantity of money supply in an economy increases, people will have
more money in their hand to spend. As a result, they will have more purchasing power to buy more goods
and services. It results to rightward shift in normal demand curve. If the quantity of money supply
decreases, it will work in the opposite direction that is demand for goods and services may decrease and the
normal demand curve may shift towards left.
Changes in Resource Allocation: If the available resources of a nation go to the hand of poor people, the
purchasing power of them will increase. As a result, the demand for basic goods may increases in the
nation. On the other hand, if the available resources of the nation are distributed in favor of rich people, the
purchasing power of them will increase. As a result the demand for luxurious goods may increase in the
economy.
Beside these factors, the demand curve may also shift due to advertisement, price expectation, discovery
of close substitute goods and change in weather.
DEMAND FUNCTION
Meaning:
Demand function is a symbolic or algebraic statement showing the relationship of dependent and independent
variables. The dependent variable represents quantity demand and independent variable represents price and
non-price factors. It can be expressed as:
DA = f (PA), ceteris paribus.
Where DA = Demand for commodity A (dependent variable)
PA = Price of commodity A (independent variable)
The equation implies that PA determines quantity demand for commodity ‘A’. To express quantitative
relationship between DA and PA the general form of linear demand function can be expressed as:
DA = a - bPA
Where a = a constant value stands as intercept at zero price
b = a constant value stands as coefficient (b = Change in Demand/ change in price)
For Example,
If
a = 500
b = 20
DA = 500 – 20 PA
The above equation shows demand price relationship. This kind of relationship can be expressed in linear and
non-linear equations.
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Types of Demand Function:
I) Linear Demand Function:
A demand function is said to be linear if the slope of demand curve remains constant throughout its
length. The general form of linear demand function is as follows:
DA = a - bPA
Here,
a = Total demand at zero point or no price demand
Change in demand
b=
Change in price
D
b=
P
b = slope of demand curve or coefficient of price
From the demand function given above, the price function can be derived as follows.
PA = a- DA/ b
Or PA = a/b – 1/bDA
When the value of PA = 0 – 20, a = 100 and b = 5 are given, the total demand schedule and linear demand curve
can be calculated as:
Demand Schedule
PA
DA = 100-5 PA
DA
0
DA = 100-5 PA = 100 – 5 x 0
100
5
DA = 100-5 PA = 100 – 5 x 5
75
10
DA = 100-5 PA = 100 – 5 x 10
50
15
DA = 100-5 PA = 100 – 5 x 15
25
20
DA = 100-5 PA = 100 – 5 x 20
0
It concludes that for any value of a, b and PA, demand function can be obtained.
When above value of DA is plotted in a graph, a linear demand curve may be derived. It is presented as follows:
Diagrammatic Representation
Fig. Linear Demand function.
12
II) Non-Linear Demand function:
 P 
 , changes all
A demand function is said to be non-linear or curvilinear when the slope of a demand curve 

Q


along the demand curve. It shows the demand curve instead of straight demand line. A non-linear demand
function can be expressed as:
DA = a PA-b ( a power function)
Diagrammatic Representation
Demand function is said to be short-term, if there is price as an independent variable.
Short term Demand Function can be expressed as follows:
DA = f (PA)
III) Long-Term Demand Function,
A demand function is said to be long-term or dynamic if there are two or more than two independent variables
or non-price factors that may result joint effect on demand.
It is expressed as :
DA = F(PA, PC, PS, Y, T, N ………)
Where, DA = Demand for a commodity A
PA = Price for a commodity A
F = functional relationship between demand and price for a commodity
Y = Income of consumer
Pc = Price of Compliment goods
Ps = Price of substitute goods
T = Tastes and preference of consumer
N = Number of consumer.
Determinants of Demand
Those factors which bring substantial change in quantity demand for a commodity without change in price of
the commodity are defined as determinants of demand. There are several non-price factors that bring changes in
quantity demand of a commodity. Some major factors that determine quantity demand are briefly explained
below:
1. Price of Related Goods: Price of related goods refers to the price of substitute goods and compliment
goods. They are briefly introduced below.
13
a. Price of Substitute Goods:
Those goods are said to be substitute which can be used in place of one to other. In case of substitute goods,
quantity demanded for one commodity may be highly affected by the price of next substitute goods. When
the price of one commodity ( say X) rises, price of substitute commodity (say Y) remaining the same, the
quantity demanded for the cheaper commodity will increase accordingly. For example, the two products,
Pepsi and Coke are supposed to be substitutes to each other. When the price of Pepsi falls (price of Coke
remaining the same), it becomes relatively cheaper than Coke. As a result the quantity demanded for Pepsi
will increase. On the other side, the quantity demanded for Coke will decrease consequently without change
in its price.
b. Price of Complement Goods:
Those goods are said to be complement which are jointly demanded to meet a particular need. Quantity
demanded for one commodity is affected by the change in prices of next commodity. In case of demand for
complement goods, as the price of a commodity rises, the price of complement goods also rises. As a result,
the quantity demanded for the complement goods will decrease and vice versa. For an example, the two
products, sugar and sweets are supposed to be complement goods to each other. When the price of sugar
rises, the price of sweets also rises. As a result, the quantity demanded for sweets will decrease. In this case,
decrease in quantity demanded for sweets is the effect of rise in price of sugar. On the other side, as the
price of sugar falls, the price of sweets also falls but the quantity demanded for the sweets will increase
consequently.
3. Income of the Consumer: Demand for some goods and services may also change along with change in
consumer’s income. Income effect on quantity demand for some goods can be analyzed as follows:
a) Demand for Inferior Goods: The good is said to be inferior if quantity demanded for it decreases along
with increase in income of the consumer and vice versa. For example, demand for bicycle becomes inferior
as the consumer's purchasing power increases even to buy motor cycle. Demand for inferior goods shows
inverse relation between price and quantity demanded.
b) Demand for Normal Goods: The good is said to be normal if quantity demanded for it increases along
with increase in income of the consumer and vice versa. For example, demand for house hold amenities
such as television, furniture, washing machine etc. Demand for normal goods shows positive relation
between price and quantity demanded.
c) Demand for Luxury Goods: The good is said to be luxury if quantity demanded for it increases after
certain level of income of consumer. For example, demand for precious stones, costly cosmetics, luxury
cars etc. Demand for luxury goods shows positive relation between price and quantity demanded.
d) Demand for Basic Goods: The good is said to be basic if quantity demanded for it remains almost fixed
or relatively inelastic to the change in income of consumer. For example, demand for water, household
energy, food, cooking oil, salt, sugar, milk etc.
Diagram for various kinds of goods
14
4. Tastes and Preferences of Consumers:
Tastes of consumers on particular good also make substantial change in quantity demanded, even if price is
rising in the market. For an example, the quantity demanded for fancy goods to young generation does not
fall despite continuous rise in price of such goods. Similarly, the quantity demand for habitual goods does
not fall though their price is rising constantly in the market.
5. Advertisement:
Goods and services, in perfectly competitive market are advertised to create more quantity demand from
consumer’s side. But advertisement of goods and services increases not only quantity demand but also the
price of goods and services. Consumers may demand more goods and services despite rise in price of
advertised goods and services due to the effect of advertisement.
6. Expectation of Change in Price:
If a consumer expects that price of a commodity is likely to fall even further in near future, more quantity
of the commodity will be demanded even if the price is falling. It is because; consumer expects that the
price of the commodity will fall even more in the future. On the contrary, as the consumer expects the
possibility of rise in price of a commodity, more unit of that commodity will be demanded even if the price
is rising. It is in a sense that price of the commodity will rise further in the future.
7. Number of Consumers:
Quantity demanded for goods and services increases along with increase in numbers of consumers despite
rise or fall in price of goods and services other things remaining same. Therefore, change in number of
consumers brings some change in quantity demanded of goods and services without change in price.
8. Technological Progress:
Introduction of new product through technological advancement may replace the old product from the
market. As a result, the demand for old product decreases despite fall in price level. On the contrary, the
demand for new product will increase even if the price is higher in the market. For an example, modern
consumers do not demand type writing machine despite fall in market price. On the other side, they demand
more computers even if the price is higher than type writing machine.
9. Consumer- Credit Facility:
Availability of credit to the potential consumers from financial institutions and even from unorganized
sources may encourage consumer to purchase more units of luxury as well as normal goods. As a result,
quantity demand for those goods increases.
10.
Changes in Resource Allocation:
If the available resources of a nation go to the hand of poor people, the purchasing power of
them will increase. As a result, the demand for basic goods may increases in the nation. On the other
hand, if the available resources of the nation are distributed in favor of rich people, the purchasing
power of them will increase. As a result the demand for luxurious goods may increase in the economy.
15
Importance of Demand Analysis in Business Decisions
1. Formulation of Strategic Business Plan:
Any business organization that aims to grow in terms of quality, quantity and efficiency should formulate
strategic plans and policies to hit the desired goals. In order to make strategic plan it has to evaluate demand
and supply condition of its product. In addition, it should calculate elasticity of demand and supply and
degree of competition in the market.
2. Resource Allocation:
Resource allocation means distribution of available resources in different aspects of production process in
scientific way. The fundamental concern of resource allocation in private organization is to maximize output
and profit of the entrepreneurs. While in government sector, the objective of resource allocation is to
maximize social welfare by making different types of policies to utilize scarce resources.
3. Demand and Sales Forecasting:
Demand and Sales forecasting are most essential task of competent business enterprises. To make such
forecasting, an efficient and competent business firms should have knowledge of demand and supply of
their product in the market. In addition, such business firms should have idea of methods of demand and
sales forecasting which is possible only from the business economics.
4. Financial Planning:
Financial management of an organization either for short-run or for long-run product is must. Financial
arrangement of any business firm also depends upon volume of quantity demanded, cost of production,
taxes, marketing and publicity costs etc. In addition, business firms set large amount of financial planning if
there is high potentiality of their product and vice versa.
5. Price Determination:
The process of product pricing is also guided by demand condition of a product. A business firm should
account cost of production and utility of the product while setting its price. On top of it, the business firm
pays special attention in demand condition of the commodity while setting final market price.
6. Determination of Output:
Volume of output and supply of a commodity largely depends upon demand for the commodity. If there is
high demand, producers have to produce more output and vice versa.
7. Identify Determinants of Demand:
Demand analysis helps to identify the determinants of demand such as income, tastes, preferences, size and
composition of production etc. Demand analysis helps to distinguish price and non-price factors and their
possible effects in demand.
8. Formulation of Tax Policy:
A government has to distinguish different commodities according to the nature and value in use and
exchange. Government can make necessary arrangement/adjustment of tax rates on goods and services as
per their demand condition. Generally, higher taxes are levied to luxury goods and no taxes to basic goods.
9. Distribution of National Income:
Distribution of national income refers to the mechanism of factor payment by the nation to its factors of
production. It is guided by the priority of development set by the nation. If it aims to enhance backward
society, it should allocate its resources for the betterment marginal people according to their needs.
10. Analysis of Consumers' Tastes and Preferences:
Study of consumer’s behavior in terms tastes and preferences of a commodity is very much issue of micro
economics. If the particular commodity is very much popular among the consumer, quantity demand goes
up even at higher price and vice versa. A business man can make necessary arrangement to supply his
product accordingly.
16
ELASTICITY OF DEMAND
Meaning
The concept of elasticity of demand, at first, was introduced by classical economists such as Courot and J.S.
Mill. Later on, the famous Neo-classical economist, Alfred Marshall developed the concept of elasticity of
demand in scientific way in the book “Principle of Economics” in 1890.
Simply, elasticity means a measurement of change in one variable in respect to the change in another variable.
The issue of elasticity plays vital role in every field of human society.
The law of demand, in deed, shows nothing other than inverse relationship between price and quantity demanded
of a commodity. But it doesn’t show, by how much quantity demanded of a commodity changes due to some
change in price of that commodity. Thus, the elasticity of demand in fact, shows degree of change in quantity
demanded of a commodity due to some change in price of a commodity.
In the words of Alfred Marshall, "The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given rise in price." In brief, elasticity of demand helps to
measure the rate of change in quantity demanded of a commodity due to some change in price of that
commodity.
Kinds of Elasticity of Demand
Elasticity of demand is broadly classified into three types. They are described below:
A. Price Elasticity of Demand
Elasticity of demand is also known as price elasticity of demand. It is reaction or responsiveness to quantity
demand of a commodity due to the change in price of that commodity, other things remaining same. It measures
the extent to which the quantity demanded of commodity changes with changes in price.
Thus, the price elasticity of demand is defined as the proportionate change in quantity demanded resulting from
proportionate change in change in price of that commodity. In the words of Mrs. Robinson, "Price elasticity is
the proportional change in quantity demanded in response to a small change in price divided by the
proportional change in price". Price elasticity of demand can be expressed in formula which has been presented
below:
Formula:
Proportionate change in quantity demanded
Price elasticity of demand =
Proportionate change in price
Changes in quantity demanded (Q)
Original quantity demanded (Q)
=
Change in price (P)
Original price (P)
In symbolic term, (EP) =
Where,
Ep
Q
P

Q P
×
P Q
= Price Elasticity,
= quantity
= price,
= small change
Types or Degrees of Price Elasticity
Types of elasticity of demand are also known as degrees of elasticity of demand. The price elasticity of demand
is classified into five types. They are discussed below.
17
1. Perfectly Elastic Demand, (Ep = ): Perfectly elastic demand is that in which quantity demanded for a
commodity becomes infinite when there is small fall in price or quantity demand turns to zero when there is
small rise in price of a commodity. This type of elasticity of demand cannot be applied in any commodity. It is
extremely rare and exceptional one. The tabular and diagrammatic representations of perfectly elastic demand
have been presented below.
Table and diagram of Perfectly Elastic Demand
Diagrammatic Representation
Y
Price
Qty.
(Rs.
per Demanded
P
kg)
(Kg)
P D
D
10
100
P
9.50

0
X
Q
Q
Q
10.50
0
Quantity Demanded
Price
2
1
1
1
2
3
Fig 2.1: Perfectly Elastic Demand Curve
The Figure 2.1 shows perfectly elastic demand, where price and quantity demanded of a commodity are
measured along ‘Y’ and ‘X’ - axes respectively. The demand curve is denoted by ‘DD1’, which is
horizontal straight line or parallel to X-axis. The demand curve ‘DD1’ indicates possibility of unlimited
increase in quantity demand of a commodity (Q1 to Q2 to Q3 . . . . Qn ) to small fall in price level ‘OP1’ and
quantity demand may become zero to small rise in price level ‘OP2’.
2. Perfectly Inelastic Demand, (Ep = 0): Perfectly inelastic demand is that in which quantity demanded for a
commodity remains almost constant to any change in price of the commodity. This means zero elasticity of
demand or perfectly inelastic demand of the commodity. This is too, an imaginary case because we cannot
observe this type of elasticity in any commodity. The tabular and diagrammatic representations of perfectly
inelastic demand have been presented below.
Table and diagram of Perfectly Inelastic Demand
Qty.
per Demanded
(Kg)
100
100
100
Y
Diagrammatic Representation
D
P2
Price
Price
(Rs.
kg)
10
12
14
P1
P
D1
M
Quantity Demanded
Fig 2.2: Perfectly Inelastic Demand Curve
O
X
The Fig 2.2 shows perfectly inelastic demand curve where price and quantity demanded are expressed
along Y-axis and X- axis respectively. The demand curve is denoted by ‘DD1’, which is absolutely parallel
to Y-axis. When the price level rises from OP1 to OP2 to OP3, quantity demanded is almost fixed to ‘OQ’
quantity. The demand curve DD1 shows no change in quantity demanded of a commodity to any change in
price level of the commodity.
3. Elastic Demand: Elastic demand is that in which the ratio of change in quantity demand for a
commodity would be greater than the ratio of change in price of the commodity. This type of elasticity
can be observed in quantity demand for luxurious goods such as car, television , computer, furniture etc.
The tabular and diagrammatic representations of elastic demand are presented below.
18
Table and diagram of Elastic Demand
Qty.
per Demanded
(Kg)
100
300
600
Diagrammatic Representation
Y
D
P2
P
Price
Price
(Rs.
kg)
12
11
10
P1
D1
Q
0
Q1
Q2
X
Quantity Demanded for Basic Goods
The Fig 2.3 shows relatively elastic demand curve where price and quantity demanded are expressed along
Y-axis and X-axis respectively. The demand curve is denoted by ‘DD1’, which is slightly slopping
downwards from left to the right. When there is small fall in price of a commodity from ‘OP2’ to ‘OP1’, the
quantity demand for the commodity increases at greater proportion from ‘OQ1’ to ‘OQ2’. Conversely, when
there is small rise in price from ‘OP1’ to ‘OP2’ the quantity demand is decreased from ‘OQ2’ to ‘OQ1’ at
greater proportion. Here, the ratio of change in price (P) is less than the ratio of change in quantity
demanded (Q) i. e. (P < Q).
4. Inelastic Demand: Inelastic demand is that in which the ratio of change in quantity demand for a
commodity would be smaller than the ratio of change in price of the commodity. This type of elasticity can
be observed in quantity demand for basic goods such as salt, rice, kerosene etc. The tabular and
diagrammatic representations of inelastic demand have been presented below.
Table and diagram of Inelastic Demand
Price
Qty.
Diagrammatic Representation
(Rs.
per Demanded
Y
D
kg)
(Kg)
30
100
20
110
P
10
120
Price
2
P
P1
0
Q
Q1
Q2
X
D1
Quantity Demanded for Basic Goods
The Fig 2.4 shows relatively inelastic demand curve where price and quantity demanded are expressed
along Y-axis and X-axis respectively. The demand curve is denoted by ‘DD1’, which is steeply slopping
downwards from left to the right. When there is greater fall in price of a commodity from ‘OP2’ to ‘OP1’,
the quantity demand for the commodity increases at smaller proportion from ‘OQ1’ to ‘OQ2’. Conversely,
when there is greater rise in price from ‘OP1’ to ‘OP2’ the quantity demand is decreased from ‘OQ2’ to
‘OQ1’ at smaller proportion. Here, the ratio of change in price (P) is greater than the ratio of change in
quantity demanded (Q) i.e. (P > Q).
19
5. Unitary Elastic Demand: Unitary elastic demand is that in which the ratio of change in quantity demand
of a commodity would be just equal to the ratio of change in price level of the commodity. This kind of
elasticity of demand is also regarded as an imaginary one. The tabular and diagrammatic representations of
unitary elastic demand have been presented below.
Table and diagram of Unitary Elastic Demand
Qty.
per Demanded
(Kg)
100
150
200
Diagrammatic Representation
Y
D
P1
Price
Price
(Rs.
kg)
60
30
15
P
P1
D1
Q
0
Q1
Q2
X
Quantity Demanded
The Fig 2.5 shows unitary elastic demand curve where price and quantity demanded are expressed along
Y-axis and X-axis respectively. The demand curve is denoted by ‘DD1’, which is smoothly slopping
downwards from left to the right. When price of a commodity falls from ‘OP 2’ to ‘OP1’, the quantity
demand for the commodity increases from ‘OQ1’ to ‘OQ2’. Conversely, when price rises from ‘OP1’ to
‘OP2’, the quantity demand decreases from ‘OQ2’ to ‘OQ1’. Here, the ratio of change in price (P) is just
equal to the ratio of change in quantity demanded (Q) i.e. .P = Q.
Measurement of Price Elasticity of Demand
The concept of price elasticity of demand is very useful in demand analysis under micro economic theory.
Basically there are three methods of measuring price elasticity of demand. They are;
1) Total outlay method /Total Expenditure method.
2) Point method.
3) Arc Method.
1) Total Outlay or Expenditure Method
The total outlay method is one of the methods of measuring price elasticity of demand. There are three cases of
elasticity of demand under it. They are:
a. Price elasticity of demand equal to unity (Ep= 1),
b. Price elasticity of demand greater than unity (Ep > 1),
c. Price elasticity of demand less than unity (Ep< 1).
The detail explanation of each kind is described with the help of table and diagram below.
a. Elasticity of Demand Equal to Unity (Ed=1): If total amount of expenditure made by consumer on a
commodity remains constant to any rise of fall in price of a commodity, it is said to be elasticity of demand
equal to unity. This type of response in expenditure to the change in price of goods and services is made by
consumers of fixed income group of the society. The following table shows the case of elasticity of demand
equal to one.
Elasticity of Demand Equal to Unity
Price of a commodity (Rs/Kg) Quantity Demanded (In Kg.) Total Expenditure (In Rs.)
20
20
400
20
40
80
10
5
400
400
The table shows that when the price of a commodity per kg rises from Rs. 20 to Rs. 40 to Rs. 80, quantity
demanded for it decreases from 20 kg to 10 kg to 5 kg respectively. But the total expenditure of a consumer
remained constant to Rs. 400 at each price level. It represents the case of price elasticity of demand equal to
unity.
b. Elasticity of Demand Greater than Unity (Ed>1): If total amount of expenditure of a consumer decreases
along with rise in price level of a commodity or total amount of expenditure increases along with fall in
price level of that commodity, the elasticity of demand is said to be greater than unity. This type of response
in expenditure to the change in price of goods and services is made by consumers of low income group of
the society. The following example shows elasticity of demand greater than unity.
Elasticity of Demand Greater than Unity
Price of a commodity (Rs/Kg) Quantity Demanded (In Kg.)
20
20
40
8
80
3
Total Expenditure (In Rs.)
400
320
240
The table shows that as the price of a commodity per kg rises from Rs. 20 to Rs. 40 to Rs. 80, quantity
demanded for it decreases from 20 kg to 8 kg to 3kg respectively. As a result the total amount of
expenditure of a consumer decreases from Rs. 400 to Rs. 320 to Rs. 240 respectively. It represents the case
of elasticity of demand greater than unity.
c. Elasticity of Demand Less than Unity (Ed < 1): If total amount of expenditure of a consumer on a
commodity increases along with increase in price level of a commodity or it decreases along with fall in
price level of that commodity, the elasticity of demand is said to be less than unity. This type of response in
expenditure to the change in price of goods and services is made by consumers of high income group of the
society. The following example shows elasticity of demand less than unity.
Elasticity of Demand Less than Unity
Price of a commodity (Rs/Kg) Quantity Demanded (In Kg.)
20
20
40
15
80
10
Total Expenditure (In Rs.)
400
600
800
The table shows that as the price of a commodity rises from Rs. 20 to Rs. 40 to Rs. 80 the quantity
demanded of a commodity decreases from 20 kg to 15 kg to 10 kg respectively. Whereas the total amount
of expenditure of a consumer increases from Rs. 400 to Rs. 600 to Rs. 800 along with increase in price level
of a commodity. It represents the case of elasticity of demand less than unity.
21
Diagrammatic Representation
Y
P
Ep > 1
Q
Price
Ep = 1
R
Ep < 1
S
O
X
Total Expenditure
In the given diagram, price of a commodity and total expenditure of a consumer are measured along ‘Y’ and
‘X’-axes respectively. The total expenditure curve is denoted by ‘PS’ which includes three different line
segments ‘PQ’, ‘QR’ and ‘RS’. The ‘PQ’ line segment of the curve ‘PS’ has negative slope, which shows
price elasticity greater than unity. It indicates that total expenditure increases when price falls and total
expenditure decreases when price rises. Similarly the ‘QR’ line segment of the curve ‘PS’ is parallel to ‘Y’axis and it shows unitary elasticity of demand. It indicates that total expenditure remains constant to any
change in price of the commodity. Finally, the ‘RS’ line segment of the curve ‘PS’ has positive slope,
which shows price elasticity of demand less than unity. It indicates that total expenditure increases with the
increase in price and total expenditure decreases with decrease in price.
2) Arc Method
The arc method was introduced by Prof. Flux to measure elasticity a demand. This method is also known as
Proportional method. It is used to measure change in quantity demanded when there is significant change in
price of commodity. Generally, the arc method is used when price level changes more than 10 percent. While
measuring piece elasticity of demand, there will be movement from one point of the demand curve to another
point making an arc along the demand curve. This method is based on average value of initial and new price
and quantity demanded in duration of time. It is expressed as:
In algebraic form:
Q p1  p2 Q1  Q 2


Ep= 
p
2
2
Q p1  P2

P Q1  Q2
Where, P  Change in Price
Q  Change in Quantity Demanded
P1 =initial price p2 =final price
Q1 =initial qty Q2 =Final qty
or Ep =
22
Diagrammatic Representation
In the given diagram, OY-axis shows- price and OX-axis shows –quantity demanded. The demand curve is
DD1.When the price is OP2, quantity demanded is OQ2.The equilibrium point is A. As the price falls from OP2
to OP1, qty demanded increases from OQ2 to OQ1, where new adjustment point is B.
Now the elasticity of demand along non-linear demand, curveDD1 is measured by taking average of price and
qty demanded from point A to point B.
 Q P 1 P2 
 , we get the required price elasticity of demand.
By applying Arc Elasticity of Demand, Ep = 


P
Q

Q
1
2 

3) Point Method
This method is also known as Geometric Method and an alternative method to Arc method. Point method is
used to measure change in quantity demanded resulted from nominal/ negligible change in price of a
commodity. (i.e. not equal to zero but near around zero percentage change in price). It measures price elasticity
at a finite/fixed point on a demand curve. It is useful where change in price and demand are very small.
Pr oportionate Change in qty demanded
Formula: Ep=
Pr oportionate change in price
Q P

P Q
The point elasticity of demand can be measured under two cases:
Case-I: Measurement under Linear Demand Curve.
Statement: Elasticity of demand at any point along the linear demand curve is measured by taking the ration of
lower segment of the curve to the upper segment of the same curve from a definite point.
The formula:
Ep=
Ep (at any point)
length of lower segment
=
length of upper segment
23
Analysis : This statement can be analyzed by the help of following diagram:
Diagrammatic representation
Here in the figure, Point elasticity at point B =
Similarly, at point C =
segment of BD
segment of AB
segment of CD
segment of AC
We can prove the above relation
Proof :
Q P

P Q
In the above figure:
Change in price (  P)= P1P2=BL
We have Ep=
Change in quantity demand (D) =Q1Q2=LC
Initial price (P) =OP1
Initial demand (Q) =OQ1
Q P

Hence Ep =
P Q
=
LC OP

BL OQ
In the  BLC and  BQ1D
 BLC =  BQ1D ------Both are Rt. angle
 Q1BC =  Q1BD----- Same angle
 LCB =  Q1DB------Corresponding
 BLC   B Q1D
In a similar triangle,
Ratio of Bases = Ratio of Perpendiculars
Ratio of LC to Q1D = Ratio of BL to BQ1
LC
BL

Q1D BQ1
By cross multiplication
24
LC Q1D

--------(1)
BL OP1
Similarly  AP1B and  BQ1D are similar.
Where,
Ratio of Bases = Ratio of hypogenous
Q1 D BD

P1 B
AB
Q1 D BD

.............(2)
OQ1 AB
The Point elasticity at point B is:
LC OP1 Q1 D OP1
EP =
(from 1 and 2)



BL OQ1 OP1 OQ1
Q D BD
EP= 1 
OQ1 AB
Lower segment
EP =
Upper segment
Hence, Proved.
25
Case II : Non linear demand curve
Elasticity of demand in Non- linear demand curve can be measured by drawing tangent to any point along the
demand curve.
Formula under this case is similar to that of linear demand curve.
Lower segment
Ep =
Upper segment
Diagrammatic Representation
Here DD1 is non- linear demand curve. To find elasticity of demand at any point along the demand curve, a
MB
tangent is drawn at point M on DD1 curve. Then, the elasticity of demand at Point M =
AM
Similarly elasticity of demand at point at N is
NE
Ep =
EN
So, it is concluded that elasticity of demand at any point along the non –linear demand curve is obtained by
dividing length of lower segment of the tangent with upper segment of the tangent.
B. Income Elasticity of Demand
The income elasticity of demand is defined as the percentage change in quantity demanded resulting from
percentage change in consumer's income. It is the responsiveness in quantity demanded to the change in
income. It measures how much the quantity demanded changes with change income, price remaining constant.
According to C.E. Ferguson "Income elasticity of demand is the proportionate change in quantity demanded
divided by proportionate change in income."
Formula:
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Income elasticity of demand =
Proportionate change in quantity demanded
Proportionate change in income
Q
Q
Symbolically, EY =
Y
Y
Types of Income Elasticity
There are three types of income elasticity of demand. They are discussed below.
1.
Zero Income Elasticity (Ey= 0)
Zero income elasticity is that in which quantity demand for a commodity remains constant to any
increase or decrease in income of the consumer. The case is applicable to some basic goods such as
salt, electricity, matches, kerosene etc. The following diagram shows zero income elasticity.
FIGURE
2.7
Zero
income
elasticity
Diagrammatic Representation
Y
D
Income
Y3
Y2
Y1
O
D1
Q
Quantity Demanded for basic goods
X
The Fig 2.7 shows zero income elasticity where income and quantity demanded are measured along
‘Y’ axis and ‘X’ axis respectively. The demand curve is represented by ‘DD1’. When there is
continuous increase in income of a consumer, from OY1 to OY2 to OY3, the unit of quantity
demanded is OQ. On the contrary, when the income of a consumer falls from OY3 to OY2 to OY1,
the quantity demand of a consumer remains fixed to OQ units. So, there is no change in demand to
any change in the income.
2. Positive Income Elasticity (Ey>0)
If the quantity demanded for a commodity increases along with increase in income of a consumer,
other things being same, it is said to be positive income elasticity of demand. For an illustration,
when consumers become rich, they spend more on luxury goods. On the contrary as they become
poor; they demand less quantity of luxury goods and move towards the demand for more inferior
goods. The case of positive income elasticity is shown in the following figure.
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FIGURE
2.8
Positive
income
elasticity
Diagrammatic Representation
Y
D
Income
Y2
Y1
D1
0
Q1
X
Q2
Quantity Demanded for Luxurious Goods
The Fig 2.8 shows positive income elasticity where income and quantity demanded are measured
along ‘Y’ axis and ‘X’ axis respectively. The demand curve is represented by ‘DD1’. When income
of a consumer increases from ‘OY1’ to ‘OY2’, the quantity demanded also increases from ‘OQ1’ to
‘OQ2’ respectively and vice versa. It shows direct relationship between income of a consumer and
quantity demanded of luxurious goods.
3. Negative Income Elasticity (Ey<0)
If quantity demanded of a commodity decreases along with increase in income of a consumers,
other things being same, it is said to be negative income elasticity of demand. For an illustration,
when consumers become rich, they stop consuming inferior goods even if the price is lower. The
case of negative income elasticity of demand is shown in the following figure.
FIGURE
2.9
Negative
income
elasticity
Y
Diagrammatic Representation
D
Income
Y2
Y1
D1
O
Q1
Q2
X
Quantity Demanded for Inferior Goods
The Fig 2.9 shows negative income elasticity of demand where income and quantity demanded are
measured along ‘Y’ axis and ‘X’ axis respectively. The demand curve is represented by ‘DD1’. The
quantity demanded of inferior goods decreases from ‘OQ2’ to ‘OQ1’ when income of a consumer
increases from ‘OY1’ to ‘OY2, respectively. On the contrary, as the income of a consumer falls
from ‘OY2 to ‘OY1’, the quantity demanded for inferior goods starts to increase consequently. It
shows inverse relationship between income of a consumer and quantity demanded of inferior
goods.
C. Cross Elasticity of Demand
The percentage change in quantity demanded of a commodity resulted from proportionate change in price of
other commodities (either complement or substitute) is called cross elasticity of demand. It is responsiveness of
quantity demanded of a commodity to the change in price of related commodities.
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According to C.E. Ferguson,” Cross elasticity is the proportion al change in quantity demanded of a
commodity (X) divided by the proportional change in the price of commodity (Y)”.
Formula:
Cross elasticity of demand
Proportionate change in Quantity demand of commodity (X)
=
Proportionate change in price of commodity (Y)
QX
PY
Symbolically,
Ec =
×
QY QX
Types of Cross Elasticity
There are two types of cross elasticity, which are based on substitute goods and complements goods.
1. Positive Cross Elasticity (Ec>1): The cross elasticity of demand is supposed to be positive if two goods are
close substitute to each other. In case of positive cross elasticity, rise in price of a commodity results to the
increase in quantity demanded of substitute goods. For example, Pepsi and coke are substitute goods to each
other. When the price of Pepsi rises, it becomes relatively expensive than coke. As a result consumers
demand more units of coke in stead of Pepsi and vice versa. The following diagram shows positive cross
elasticity of demand.
Y
Diagrammatic Representation
Price of X
D
P1
PX
P
D1
QY
M
M1
Quantity Demanded of Y
Fig : Positive Cross Elasticity of Demand
X
The Fig shows positive cross elasticity of demand, where price of X is in Y-axis and quantity demanded for
Y is X-axis. The demand curve ‘DD1’ shows positive cross elasticity of demand. Here two commodities X
and Y are supposed to be substituted to one another. As the price of commodity ‘X’ rises from ‘OP’ to
‘OP1’ by Px, some units of commodity Y increases from ‘OM’ to ‘OM1’ by Qy, consequently. On the
contrary, As the price of commodity ‘X’ falls from ‘OP1’ to ‘OP’ by Px, some units of commodity Y
decreases from ‘OM1’ to ‘OM’ by Qy, consequently. This is the case of substitute goods under positive
cross elasticity of demand.
2. Negative Cross Elasticity (Ec<1): The cross elasticity of demand is said to be negative when two goods are
complement to one another. In case of negative cross elasticity of demand, rise in price of a commodity
results to the decrease in quantity demanded of complement goods. For example, sweets and sugar are
complement goods to each other. When the price of sugar rises, it becomes expensive. As a result, price of
sweets also rises consequently. Finally, the quantity demanded for sweets decreases due to the rise in price
of sugar. On the contrary, if the price of sugar falls, it becomes cheaper. As a result, price of sweets also
falls consequently. Finally, the quantity demanded for sweets increases due to the fall in price of sugar. The
following diagram shows negative cross elasticity of demand.
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Y
Diagrammatic Representation
Price of X
D
P1
P
PX
D1
Qy
0
M1
M
Quantity Demanded for Y
Fig : Negative Cross Elasticity of Demand
X
The Fig shows negative cross elasticity where the demand curve is denoted by ‘DD1’ which shows negative
cross elasticity. Here two commodities ‘X’ and ‘Y’ are supposed to be complement to one another. As the
price of commodity ‘X’ rises from ‘OP’ to ‘OP1’ by Px, some units of commodity Y decreases from ‘OM’
to ‘OM1’ by Qy, consequently. On the contrary, As the price of commodity ‘X’ falls from ‘OP 1’ to ‘OP’
by Px, some units of commodity Y increases from ‘OM1’ to ‘OM’ by Qy, consequently. This is the case
of substitute goods under negative cross elasticity of demand.
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Factors Determining Elasticity of Demand
The elasticity of demand is determined by several factors which are briefly explained below:
1. Availability of Substitute Goods: Elasticity of demand highly depends upon availability of substitute
goods. Some goods may have substitute where as some of them may not.
Case I: Those goods which have close substitute, the quantity demanded of them becomes relatively
elastic. For example, tea and coffee are close substitute goods to each other. If the price of tea rises
(price of coffee remaining same) the quantity demanded for coffee also increases. So the demand
for coffee is elastic.
Case II: Those goods which are not close substitute, the quantity demanded of them becomes relatively
inelastic. For example, demand for salt and cloth is relatively inelastic because change in price of
salt does not change quantity demanded for cloths.
2. Nature of Commodity: The elasticity of demand depends even to the nature of a commodity.
Case I: Demand for basic goods such as salt, rice, kerosene, electricity is supposed to be relatively inelastic
because greater change in price of them brings small change in their quantity demand. Consumers
must consume those goods at any cost by any means to meet their basic requirements.
Case II: Demand for luxurious goods such as television, vehicles, washing machine etc is supposed to be
relatively elastic in a sense that small change in their price results greater change in quantity
demand of such goods. Consumption of those goods is optional because one can run their life with
out those goods.
3. Goods of Several Uses: Some goods available to us can fulfill many purposes. For example, demand for
electricity is one of these kinds.
Case I: When the price of electricity rises, consumers use it only for specific purpose like lighting. As a
result, the demand for it becomes relatively inelastic.
Case II: If the price of electricity falls, consumers may use that commodity for several purposes like
cooking, washing clothes, pressing clothes, watching television and listening radio. In this situation
the demand for electricity becomes relatively elastic.
4. Level of Income: Elasticity of demand also depends on level of income of the consumers.
Case I: Rich consumers do not respond to small change in price of goods and services. Quantity demand
for any type of commodity remains relatively inelastic to rich consumers to the small change in
price of a commodity because they can afford any amount of money to meet their needs.
Case II: Poor consumers respond sincerely towards small change in prices of goods and services. Quantity
demand for any type of commodity becomes relatively elastic to poor consumers to the small
change in price because they cannot afford much amount of money to meet their needs.
5. Availability of Time: Time factor also plays a vital role in consumption or purchase of a commodity.
Case I: If a consumer has a sufficient time to buy a commodity, the quantity demand would be relatively
elastic because the consumer can have sufficient time to find cheaper one or making bargaining in
purchase of the commodity.
Case II: If a consumer has not a sufficient time to buy a commodity, the quantity demand would be
relatively inelastic because the consumer has to purchase the commodity at any price in short time
without making bargaining in purchase of the commodity.
6. Joint Demand: Some commodities are jointly demanded to meet a particular need or want. For example
demand for pen and ink, motorcycle and petrol etc.
Case I: If the quantity demand for major commodity is relatively elastic, the quantity demand for minor
one also becomes relatively elastic. For example, if the demand for motorcycle is relatively elastic,
the demand for petrol would also become relatively elastic.
Case II: If the quantity demand for major one is relatively inelastic, the quantity demand for minor one
would also be relatively inelastic. For example, if the demand for motorcycle is relatively inelastic,
the demand for petrol would also become relatively inelastic.
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7. Habitual Necessities: Some goods such as wine, cigarette, and drugs are known as habitual necessities.
Consumers who have got habit to consume those goods do not respond to the small change in their
price. The quantity demand remains relatively inelastic to any rise or fall in price level. The demands for
those goods are defined as relatively inelastic in nature.
8. Postponement of Some Goods Consumption: Consumers may change consumption habit according to
the situation. For instance, a consumer may stop smoking cigarette once cancer catches him or her and
demand for cigarette turns to zero or nil. Therefore, postponement of consumption of certain goods also
determines elasticity of demand and supply of these goods.
Importance of Cross Elasticity of Demand
1) To analyze effect on demand for substitute goods as well as of complement goods, due to the change in
price of these kind of goods.
2) To distinguish substitute and complement goods.
3) To demarked boarder line producing two or many commodity of producing two or many commodities.
4) To measure inter-relation or dependency of firms in market.
Importance of Income Elasticity
1) Study on effect of Trade cycle in Business
Case I: Income elasticity even during boom and slump will be inelastic to the
demand for basic
goods. So producer may continue production of these goods.
Case II: Income elasticity during boom will be high to the demand for luxury goods. So producers have
to invest in luxury goods production.
Case III: Income Elasticity during slump will be low to the demand for luxury goods, so one should
focus on production of inferior and normal goods.
2) Study on Market Activity.
Increase in per capita income accelerates the activities such as marketing, advertisement or publicity to
create new demand. Higher the income elasticity, greater be the demand for normal and luxury goods.
3) To make market strategy
The strategy of publicity for a commodity depends upon to whom the commodity is being produced. If a
product is of luxury nature it has to be publicized through television. On the other side if a product is of
normal goods, it may be advertised through newspaper, radio and so on.
Importance of Price Elasticity of Demand
Price elasticity of demand has its practical application in many walks of economic life. It is used in the sectors
of budget formulation, price determination and control over inflation, deflation, and trade cycle. Brief
discussion its uses are as follows;
1. Price Determination under Free Market: The process of price determination of a commodity under
free market is a matter of great challenge. Producers have to analyze the elasticity of demand for basic
or luxury goods, goods of close substitute, habitual goods, and goods of multiple uses before fixing their
prices. For instance; High price have to be charged on goods of basic needs, habitual goods, and durable
goods due to their inelastic demand. On the contrary, low price should be charged to luxury goods,
goods of close substitute and goods of multiple uses due to their elastic demand. Therefore, knowledge
of elasticity of demand is must to the producers and sellers to meet the goal of profit maximization.
2. Price Determination under Imperfect Market and Monopoly: Imperfect market comprises few
numbers of firms producing substitute goods. When a producer makes negligible change in price of his
product, the rival firms make immediate reaction to the price of the products due to the possibility of
loosing the limited market. Therefore, one should analyze elasticity of demand of the product while
fixing the price. If elasticity of demand for a commodity is greater than unity, the demand is supposed to
be flexible, so one should set low price level and vice versa. In case of monopoly producer, he/she can
charge different price in different market according to the income status and access of consumer in the
market.
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3. Study of Consumer’s Status: If quantity demanded for luxury or expensive or capital goods by a
consumer does not change to the change in price level (inelastic demand), one should think that the
consumer might be high income group and vice versa.
4. To Make Factor Payment: The factors of production land, labor, capital and organization are paid in
terms of rent, wages, interest and profit. If the demand for those factors of production is inelastic in the
market, producers have to pay higher price to use them. On the contrary, if their demand is elastic or
flexible, lower price may be given.
5. To Correct Deficit BOP and BOT: BOP stands for Balance of Payment and BOT stands for Balance
of Trade of a nation. If a nation has unfavorable BOP, it may devaluate domestic currency to discourage
foreign imports and promote national exports. It is because, devaluation of domestic currency may raise
price of foreign products and fall in price of domestic products. As a result, large quantity of domestic
product may be exported and the negative BOP as well as BOT may move towards positive direction.
6. To Make Economic Policies: Various economic policies such as fiscal policy, monetary, policy
banking policy are formulated according to the elasticity of demand of various kinds of goods and
services. For instance, elasticity of government expenses depends upon volume of its revenue, volume
of volume of government revenue depends upon elasticity of tax rates imposed on goods and services.
Volume of capital investment rests upon elasticity of bank interest rate, quantity of export and import
lies upon elasticity of custom duties and so on. Therefore, while making macro economic policies,
analysis of elasticity of demand and supply about the concerned subject is must.
7. Determination of Foreign Exchange Rate: A nation aims to maintain stability of domestic currency
with that of concerned foreign currencies. In order to meet this goal, adjustment of exchange rate should
be carried out very sincerely. There should be proper analysis on effect of change in exchange rate with
help of elasticity of demand and supply of exports and imports.
8. Determination of Prices of Public Utilities: A government has to set reasonable price of electricity,
drinking water, education, transportation to provide maximum welfare to the citizens. Since these
utilities are basic needs of common people, negligible change in price level may cause economic and
political instability in the economy. Therefore, analysis of elasticity of demand and supply of these
goods and services must essential to minimize the effect of change in price structure.
9. Determination of Minimum Price of Agricultural Products: Quantity of agricultural production is
subject to change according to season, supply of inputs, availability of skilled human resource, facility
of irrigation, natural calamities and ware house facilities. Due to these factors, supply of farm products
and their price alter accordingly. Therefore, government should make proper analysis of production and
should fix product price on the basis of elasticity of supply and demand to place the farmers in favorable
position.
Exercise:
1. What do you meant by demand function? Explain the types of demand function?
2. Discuss the determinants of demand? Why demand analysis is important in business economics?
3. Define price elasticity of demand? Discuss the types of price elasticity of demand.
4. Show that how price elasticity of demand is measured under point method.
5. Explain the uses of price elasticity of demand.
6. Briefly discuss on the law of diminishing marginal utility. How a consumer maintains equilibrium
under one commodity case?
7. Explain the measurement of price elasticity of demand under total outlay and arc method.
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