flowchart LR PD[Price decrease] --> SE[Substitution effect<br/>X cheaper vs substitutes] PD --> IE[Income effect<br/>Real income rises] SE --> Q[Quantity demanded<br/>increases] IE --> Q style PD fill:#FFEBEE,stroke:#C62828 style Q fill:#E8F5E9,stroke:#1B5E20
7 Demand Analysis
7.1 What is Demand?
In everyday language, demand often means desire. In economics, the word is more disciplined. Demand is the quantity of a good or service a consumer is willing and able to buy at a given price during a given period of time, all else being equal. Three elements distinguish demand from mere wanting (dwivedi2015?):
- Willingness — the consumer wants the good.
- Ability — the consumer can pay for it.
- A definite price and time period — demand is a flow concept, measured per day, week or year.
Mankiw’s textbook formulation is identical (mankiw2020?). A demand schedule shows the relationship between price and quantity demanded; a demand curve is its graphical form.
7.2 The Law of Demand
The most-tested proposition in economics: other things remaining the same, the quantity demanded of a good rises when its price falls and falls when its price rises. The relationship is inverse.
Two reasons drive the law:
- Substitution effect. When the price of good X falls, X becomes cheaper relative to its substitutes; consumers buy more of X.
- Income effect. A price fall raises the consumer’s real income; if X is a normal good, more of it is bought.
7.2.1 Exceptions to the Law
TipWhere the Law Breaks Down
| Case | Why the demand curve slopes upward |
|---|---|
| Giffen goods | Strongly inferior staples — when price rises, the income effect outweighs the substitution effect (Sir Robert Giffen’s observation on Irish potatoes) |
| Veblen / status goods | Higher price signals exclusivity and raises desirability — luxury watches, designer handbags |
| Speculation | If buyers expect prices to rise further, current demand rises with the current price |
| Necessities of life | Sometimes argued for unavoidable items — controversial |
| Ignorance about quality | Consumers may treat price as a proxy for quality |
The Giffen and Veblen cases are the only widely accepted exceptions.
7.3 Determinants of Demand
The “other things being equal” clause hides the determinants. The standard list:
TipDeterminants of Demand
| Determinant | Direction of effect on demand |
|---|---|
| Price of the good itself | Inverse — covered by the law of demand |
| Income of the consumer | Direct for normal goods; inverse for inferior goods |
| Price of related goods | Substitutes → direct; complements → inverse |
| Tastes and preferences | Demand shifts with fashion, advertising, lifestyle |
| Consumer expectations | If price expected to rise, current demand rises |
| Population / number of buyers | Direct |
| Distribution of income | Affects aggregate demand pattern |
| Government policy | Taxes lower demand; subsidies raise it |
A change in price moves the consumer along the same demand curve — change in quantity demanded. A change in any other determinant shifts the entire curve — change in demand. NTA stems often hinge on this distinction.
7.4 The Demand Function
The demand function compresses all the determinants into one expression.
\[Q_d = f(P, P_r, Y, T, E, N, G)\]
where \(P\) is the own price, \(P_r\) the price of related goods, \(Y\) income, \(T\) tastes, \(E\) expectations, \(N\) population, and \(G\) government policy. A linear demand function for empirical work might be \(Q_d = a - bP\) — the slope \(-b\) captures the law of demand.
7.5 Types of Demand
TipUseful Classifications of Demand
| Basis | Categories | Quick example |
|---|---|---|
| Nature | Normal vs Inferior goods | Branded rice vs coarse rice |
| Direct vs Derived | Demand for the final good vs for inputs | Demand for cars vs demand for steel |
| Producer vs Consumer | Used as input vs final consumption | Cement to a builder vs cement to a homeowner |
| Joint demand | Two goods demanded together | Bread and butter |
| Composite demand | Same good wanted for different uses | Milk for tea, cheese, ghee |
| Short-run vs Long-run | Time horizon | Demand for petrol today vs demand for cars over five years |
| Recurring vs Replacement | Regular vs occasional purchase | Toothpaste vs refrigerator |
| Industry vs Firm | Total market vs one seller’s slice | All cement vs ACC’s cement |
7.6 Elasticity of Demand
Marshall’s most influential contribution to applied economics. Elasticity measures the responsiveness of quantity demanded to a change in one of its determinants. Three elasticities matter for managerial decisions.
7.6.1 Price Elasticity of Demand (ep)
\[e_p = \frac{\% \text{ change in } Q_d}{\% \text{ change in } P}\]
By convention the sign is reported as positive (the absolute value).
TipFive Degrees of Price Elasticity
| Value of ep | Type | Demand curve | Example |
|---|---|---|---|
| ep = 0 | Perfectly inelastic | Vertical | Insulin for a diabetic |
| 0 < ep < 1 | Inelastic | Steep | Salt, kerosene |
| ep = 1 | Unit elastic | Rectangular hyperbola | Theoretical benchmark |
| 1 < ep < ∞ | Elastic | Flat | Branded soft drinks, restaurant meals |
| ep = ∞ | Perfectly elastic | Horizontal | A small farmer’s wheat in a perfect market |
Determinants of price elasticity: availability of substitutes; share in the consumer’s budget; nature of the good (necessity vs luxury); time horizon (longer → more elastic); habit; durability.
Why managers care. When demand is inelastic, a price rise increases total revenue. When demand is elastic, a price cut increases total revenue. The sign of the price-revenue relationship flips at ep = 1.
TipPrice Change × Elasticity → Total Revenue
| Price change | Elastic demand | Inelastic demand |
|---|---|---|
| Price rises | Revenue falls | Revenue rises |
| Price falls | Revenue rises | Revenue falls |
7.6.2 Income Elasticity (ey)
\[e_y = \frac{\% \text{ change in } Q_d}{\% \text{ change in income}}\]
TipIncome Elasticity by Goods Type
| ey | Goods type | Example |
|---|---|---|
| ey < 0 | Inferior | Coarse rice, public transport |
| 0 < ey < 1 | Necessities (normal) | Salt, basic food |
| ey > 1 | Luxuries (normal) | Imported cars, fine dining |
| ey = 0 | Income-neutral | Matchsticks |
7.6.3 Cross-Price Elasticity (exy)
\[e_{xy} = \frac{\% \text{ change in } Q_d \text{ of } X}{\% \text{ change in price of } Y}\]
- exy > 0 → X and Y are substitutes (tea and coffee).
- exy < 0 → X and Y are complements (cars and petrol).
- exy = 0 → unrelated goods.
The size of exy also signals how closely substitutable the goods are — useful for defining markets in competition law.
7.6.4 Methods of Measuring Price Elasticity
Three standard methods (Dwivedi):
TipThree Measurement Approaches
| Method | When to use | Formula / approach |
|---|---|---|
| Percentage method | Discrete changes | (% change in Q) / (% change in P) |
| Point elasticity | Infinitesimally small changes on a curve | (dQ/dP) × (P/Q) |
| Arc elasticity | Larger changes between two points | \(\frac{Q_2 - Q_1}{(Q_1 + Q_2)/2} \div \frac{P_2 - P_1}{(P_1 + P_2)/2}\) |
7.7 Demand Forecasting
Demand forecasting is the process of estimating future demand — the input to almost every other managerial decision. The classification used in Indian texts (Dwivedi; Mehta):
TipMethods of Demand Forecasting
| Group | Method | Idea |
|---|---|---|
| Survey methods | Consumer survey, expert opinion (Delphi), sales-force opinion, market experiment | Ask people |
| Statistical methods | Trend projection, moving averages, exponential smoothing, regression | Project from data |
| Other | Barometric / leading indicators, end-use / input-output method, simulation | Rely on signals or causal models |
Survey methods are quick and cheap but rest on respondent honesty; statistical methods need clean past data and a stable structure; barometric and end-use methods are useful when historical data is thin but a clear cause is identifiable.
A good forecast satisfies five tests: accuracy, plausibility, durability, flexibility, availability of data.
7.8 Practice Questions
Q 01
Law of Demand
Easy
The law of demand states that, other things equal, quantity demanded:
View solution
Correct Option: B
The law is the inverse relation between price and quantity demanded. Driven by substitution and income effects.
Q 02
Exceptions
Medium
A good for which a rise in price increases the quantity demanded because of a strong negative income effect is called:
View solution
Correct Option: B
Giffen goods are strongly inferior staples; the income effect dominates the substitution effect. Veblen goods rise in demand for status, not on income grounds.
Q 03
Movement vs Shift
Medium
A change in the price of a good causes a:
View solution
Correct Option: B
Own-price changes cause movement along the curve (change in quantity demanded). Other determinants cause shifts of the curve (change in demand).
Q 04
Elasticity Types
Medium
If a 5% rise in the price of tea raises the demand for coffee by 8%, the cross-price elasticity is:
View solution
Correct Option: A
e~xy~ = 8 / 5 = +1.6. Positive sign → substitutes.
Q 05
Income Elasticity
Easy
A negative income elasticity of demand indicates that the good is:
View solution
Correct Option: C
e~y~ < 0 → consumers buy less of the good as income rises → inferior good (e.g., coarse rice).
Q 06
Pricing
Medium
For a firm whose product has price-elastic demand, raising the price will:
View solution
Correct Option: B
When demand is elastic, the percentage drop in quantity is larger than the percentage rise in price → revenue falls.
Q 07
Curve Shape
Easy
A perfectly inelastic demand curve is:
View solution
Correct Option: B
e~p~ = 0 → the same quantity is bought at every price → the curve is vertical.
Q 08
Forecasting
Medium
Which of the following is a statistical method of demand forecasting?
View solution
Correct Option: C
A, B and D are survey / qualitative methods. Trend projection by regression is a statistical method.
ImportantQuick recall
- Demand = willingness + ability + a price + a time period. Demand is a flow.
- Law of demand: inverse price-quantity relation, driven by substitution and income effects. Exceptions: Giffen and Veblen goods.
- Movement along the curve = own-price change. Shift of the curve = any other determinant changes.
- Three elasticities: Price (ep), Income (ey), Cross (exy). exy > 0 → substitutes; exy < 0 → complements.
- TR rule: elastic + price up → revenue falls; inelastic + price up → revenue rises.
- Goods classification by ey: inferior (ey<0), necessity (0<ey<1), luxury (ey>1).
- Forecasting methods: survey, statistical, barometric, end-use. Tests: accuracy, plausibility, durability, flexibility, data.