Theory of Demand

3–4 minutes

Last updated on November 28th, 2019 at 11:07 pm

Demand theory is an economic principle relating to the relationship between consumer

demand for goods and services and their prices in the market. Demand theory forms the basis
for the demand curve, which relates consumer desire to the amount of goods available. As
more of a good or service is available, demand drops and so does the equilibrium price.

Demand theory highlights the role that demand plays in price formation, while supply-side
theory favors the role of supply in the market.

Demand Theory

Demand is simply the quantity of a good or service that consumers are willing and able to
buy at a given price in a given time period. People demand goods and services in an economy
to satisfy their wants, such as food, healthcare, clothing, entertainment, shelter, etc. The
demand for a product at a certain price reflects the satisfaction that an individual expects
from consuming the product. This level of satisfaction is referred to as utility and it differs
from consumer to consumer. The demand for a good or service depends on two factors:

(i) Its utility to satisfy a want or need

(ii) The consumer’s ability to pay for the good or service. In effect, real demand is when the
readiness to satisfy a want is backed up by the individual’s ability and willingness to pay.

Demand theory is one of the core theories of microeconomics. It aims to answer basic
questions about how badly people want things, and how demand is impacted by income
levels and satisfaction (utility). Based on the perceived utility of goods and services by
consumers, companies adjust the supply available and the prices charged.

Built into demand are factors such as consumer preferences, tastes, choices, etc. Evaluating
demand in an economy is, therefore, one of the most important decision-making variables
that a business must analyze if it is to survive and grow in a competitive market. The market
system is governed by the laws of supply and demand, which determine the prices of goods
and services. When supply equals demand, prices are said to be in a state of equilibrium.
When demand is higher than supply, prices increase to reflect scarcity. Conversely, when
demand is lower than supply, prices fall due to the surplus.

 Demand theory describes the way that changes in the quantity of a good or service
demanded by consumers affects its price in the market,
 The theory states that the higher the price of a product is, all else equal, the less of it
will be demanded, inferring a downward sloping demand curve.
 Likewise, the more demand that occurs, the greater the price will be for a given
supply.
 Demand theory places primacy on the demand side of the supply-demand
relationship.

Types of Demand
5–6 minutes

Last updated on November 28th, 2019 at 11:07 pm

Consumer demand for a product may be viewed at two levels:

1. Individual demand, and

2. Market demand.

Individual demand:

Refers to the demand for a commodity from an individual. That quality of a commodity a
consumer would buy at a given price during a given period of time is his individual demand
for that particular commodity.

In economics, ‘demand’ refers to the quantity of a good or service that consumers

are willing and able to purchase at a given price. Different from what consumers desire to
purchase, demand explains what they are actually able to purchase. Not all desires can be met
for the reason that goods are guided by prices in the market. At higher prices, consumers
would want to buy less of a good and the reverse is true for lower prices. This relation is the
famous law of demand.

Another reason that desires are not the same as actual consumer decisions is that consumers
are constrained by their budget. The money income of a consumer will limit his ability to
purchase a commodity. Thus, demand expresses both willingness and ability to consume.
Willingness is depicted by consumer preferences and ability is depicted by constraints such
as money income and prices (budget constraint).

Market demand:

For a product on the other-hand refers to the total demand of all the individual buyers taken
together. How much in quantity the consumers in general would buy at a given price during a
given period of time constitutes the total market demand for the product.

Individual demand is the demand of a single consumer for a good or service at a given price,
with other factors as money income, tastes, and preferences, prices of other goods constant. It
can be graphically depicted by a downward sloping demand curve for a single consumer. The
curve represents different price-quantity combinations available to a consumer to consume.
Market demand refers to the demand of all consumers of a good or service at a given price,
with other factors as money income, tastes, and preferences, prices of other goods constant. It
is called ‘market’ demand because it depicts the market situation for a good or service. It can
be graphically obtained by aggregating the individuals’ consumer demand for a commodity.
In simple words, the horizontal summation of all individual demand curves for a good or
service gives you the market demand curve.

Market demand is the sum of individual demands. It is derived by aggregating all individual
buyers’ demands in the market. This demand is more important from the seller’s point of
view. Sales depend on the market demand. Business policy and planning are based on the
market demand. Prices are determined on the basis of market and not of just an individual
demand for the product.

Kinds of Demand:

There are three kinds of demand:

1. Price demand,

2. Income demand, and

3. Cross demand.

1. Price Demand:

Price demand is that demand which refers to the various quantities of a commodity or service
that a consumer would purchase at a given time in a market at various hypothetical prices. In
this it is always assumed that other things such as consumer’s income, his tastes and prices of
related goods remain unchanged.

This type of demand has been classified under three heads:

(a) Individual Demand:

Individual demand is the demand of an individual consumer.

(b) Industry Demand:

It is the aggregate demand of all the consumers combined for the commodity.

(c) Firm’s Demand or Individual Seller’s Demand:

This is the total demand for the product of an individual firm at various prices.

2. Income Demand:

This demand refers to the various quantities of goods which will be purchased by the
consumer at various levels of income. In this, we start with this assumption that the price of
the commodity as well as the price of related goods and the tastes and desire of the
consumers do not change. The demand brings out the relationship between income and
quantities demanded. This is helpful in preparing demand schedule.

3. Cross Demand:

In this demand the quantities of goods which will be purchased with reference to changes in
the price not of this goods but of other related goods. These goods are either substitutes or
complementary goods. For example—A change in the price of tea will affect demands for
coffee. Similarly, if the price of horses will become cheap demand for carriages may
increase.

Determinants of Demand
Demand is fluctuating time to time. There are majorly six factors which affect the demand for
a commodity (Product).

Determinants of Demand Mean

1. Consumer preferences: personality characteristics, occupation, age, advertising, and

product quality, all are key factors affecting consumer behavior and, therefore,
demand.

2. Prices of related products: an increase in the price of one product will cause a
decrease in the quantity demanded of a complementary product. In contrast, an
increase in the price of one product will cause an increase in the demand for a
substitute product.

3. Consumer income: the higher the consumer income, the higher the demand and vice
versa.

4. Consumer expectations: expectations for a higher income or higher prices increase

the quantity demanded. Expectations for a lower income or lower prices decrease the
quantity demanded.

5. The number of buyers: the higher the number of buyers, the higher the quantity
demanded, and vice versa.

6. Other factors: the weather and governmental policies that may expand or contract
the economy affect the demand for particular products or services.

Demand Function
The demand function shows the relation between the quantity demanded of a commodity by
the consumers and the price of the product. These functions are probably the most important
tools used by economists. While many variables determine the quantity consumers wish to
purchase in a market, the price of the commodity is perhaps the most important one.

In this context, we may distinguish between individual demand and market demand. The
former refers to the quantity of a good that an individual stands ready to buy at each of
several prices, at a particular time, under given conditions.

The latter consists of the total quantity of a good that would be bought in the aggregate by
individuals and firms, at each of the various prices, at a fixed point of time. The demand
schedules may be graphed or shown in a tabular form. When a demand schedule is graphed, it
is called the demand curve.

Now we may suggest the following definition of a demand function:

A demand function is a list of prices and the corresponding quantities that individuals are
willing and able to buy at a fixed point of time. We may note at the outset that demand is a
function (or schedule), not a specific quantity. It is formally defined as a schedule of the total
quantities of a commodity or service that will be purchased at various prices at a particular
point of time.

Hence when we refer to the demand for meat or the demand for motors cars in India, we are
considering the amounts that consumers are willing and able to purchases at various prices.

The word ‘demand’ is a broad concept referring to the entire schedule of quantities and
prices. But the term ‘quantity demanded’ refers to a single point on the demand schedule or
curve. It shows the maximum quantity demanded at a particular price.
We generally specify consumer demand in any of the three ways: as a schedule, a graph, or a
function. This table shows the list of prices and the corresponding quantities that the
consumers demand per unit of time (a day or a week).

Quite often it is more convenient to work with the graph of a demand schedule, called a
demand curve, rather than with the schedule itself. Figure shows the demand curve which is a
graphical representation of the demand schedule presented in Table. Each price-quantity
combination — (Rs. 6, 2,000), (Rs. 5, 3,000), and so on — is plotted. The locus of such
points (each one showing a particular combination of p and q) DD’ is the demand curve.

The demand curve indicates the quantity of the good consumers are willing and able to buy at
a fixed point of time at alternative prices, i.e., at every price from Rs. 6 to Rs. 1. Since price
and quantity demanded are inversely related, the curve slopes downward.

Indeed, all market demand curves (which are arrived at by adding up demand curves of
individual consumers) are downward sloping because of the law of demand. Individuals
purchase less when price rises. Furthermore, as price increases, some individuals do not
purchase anything at all, again causing the quantity demanded at each price to fall.

Alternatively, we can express demand as a function

Qx = ƒ(Px)
In this function, the other variables (income, and so on) are held constant. The quantity
demanded of a commodity is a function of the price of the good, holding constant the other
(proximate) determinants of demand.

Demand Schedule
A demand schedule is a chart that shows the number of goods or services demanded at
specific prices. In other words, it’s a table that shows the relationship between the price of
goods and the amount of goods consumers are willing and able to pay for them at that price.

This schedule is based on the demand curve that illustrates inverse relationship between
quantities demanded and price. As the price of a good increases, the quantity demanded
decreases.

The table simply takes the plotted points on the demand curve and puts them on a table. In an
effort to plan production processes, management can look at the schedule and figure out how
many units consumers will demand based on the price.

They can also use this schedule to maximize profits by pricing goods or services according to
their demand elasticity. In other words, they might be able to maximize profits by selling
fewer high priced goods than many more low priced goods.

Example

Alex, a new storeowner, wants to estimate the demand for his goods, so he gives a survey to
his potential customers. The survey is comprised of different prices they would be willing to
pay for the same product. Every participant in the survey is asked to provide the highest
dollar amount they would pay.

He collects the surveys then plots them with a demand curve with quantity demanded on X-
axis and Price on Y-axis. It shows that at $4.99, 14 people would buy the product and at
$6.99, 10 people would buy it. Going down the list of prices he makes a table showing the
amount demanded according to each price. Using this schedule, Alex can make decisions on
how much to charge and how it will affect his profits.

The demand schedule is often accompanied by a supply schedule. The point at which both
charts intersect is called the equilibrium. This price and quantity is the optimal point for the
market.

Demand Schedules vs. Supply Schedules

A demand schedule is typically used in conjunction with a supply schedule, which shows the
quantity of a good that would be supplied to the market by producers at given price levels. By
graphing both schedules on a chart with the axes described above, it is possible to obtain a
graphical representation of the supply and demand dynamics of a particular market.

In a typical supply and demand relationship, as the price of a good or service rises, the
quantity demanded tends to fall. If all other factors are equal, the market reaches equilibrium
where the supply and demand schedules intersect. At this point, the corresponding price is the
equilibrium market price, and the corresponding quantity is the equilibrium quantity
exchanged in the market.

TAKEAWAYS

 Analysts can estimate the demand for a good at any point along the demand schedule.
 Demand schedules, used in conjunction with supply schedules, provide a visual
depiction of the supply and demand dynamics of a market

Demand Curve
The demand curve is a graphical representation of the relationship between the price of a
good or service and the quantity demanded for a given period of time. In a typical
representation, the price will appear on the left vertical axis, the quantity demanded on the
horizontal axis.

The demand curve is a visual representation of how many units of a good or service will be
bought at each possible price. It plots the relationship between quantity and price that’s been
calculated on the demand schedule. That’s a table that shows exactly how many units of a
good or service will be purchased at various prices.

Understanding the Demand Curve

The demand curve will move downward from the left to the right, which expresses the law of
demand — as the price of a given commodity increases, the quantity demanded decreases, all
else being equal.

Note that this formulation implies that price is the independent variable, and quantity the
dependent variable. In most disciplines, the independent variable appears on the horizontal or
x-axis, but economics is an exception to this rule.

For example, if the price of corn rises, consumers will have an incentive to buy less corn and
substitute it for other foods, so the total quantity of corn consumers demand will fall.

Demand curves generally have a negative gradient indicating the inverse relationship
between quantity demanded and price.
There are at least three accepted explanations of why demand curves slope downwards:

 The law of diminishing marginal utility

 The income effect
 The substitution effect

Law of Demand
The law of demand is one of the most fundamental concepts in economics. It works with the
law of supply to explain how market economies allocate resources and determine the prices
of goods and services that we observe in everyday transactions. The law of demand states that
quantity purchased varies inversely with price. In other words, the higher the price, the lower
the quantity demanded. This occurs because of diminishing marginal utility. That is,
consumers use the first units of an economic good they purchase to serve their most urgent
needs first, and use each additional unit of the good to serve successively lower valued ends.

 The law of demand is a fundamental principle of economics which states that at higher price
consumers will demand a lower quantity of a good.
 Demand is derived from the law of diminishing marginal utility, the fact that consumers use
economic goods to satisfy their most urgent needs first.
 A market demand curve expresses the sum of quantity demanded at each price across all
consumers in the market.
 Changes in price can be reflected in movement along a demand curve, but do not by
themselves increase or decrease demand.
 The shape and magnitude of demand shifts in response to changes in consumer preferences,
incomes, or related economic goods, NOT to changes in price.

Understanding the Law of Demand

Economics involves the study of how people use limited means to satisfy unlimited wants.
The law of demand focuses on those unlimited wants. Naturally, people prioritize more
urgent wants and needs over less urgent ones in their economic behavior, and this carries over
into how people choose among the limited means available to them. For any economic good,
the first unit of that good that a consumer gets their hands on will tend to be put to use to
satisfy the most urgent need the consumer has that that good can satisfy.

For example, consider a castaway on a desert island who obtains a six pack of bottled, fresh
water washed up on shore. The first bottle will be used to satisfy the castaway’s most
urgently felt need, most likely drinking water to avoid dying of thirst. The second bottle
might be used for bathing to stave off disease, an urgent but less immediate need. The third
bottle could be used for a less urgent need such as boiling some fish to have a hot meal, and
on down to the last bottle, which the castaway uses for a relatively low priority like watering
a small potted plant to keep him company on the island.

In our example, because each additional bottle of water is used for a successively less highly
valued want or need by our castaway, we can say that the castaway values each additional
bottle less than the one before. Similarly, when consumers purchase goods on the market
each additional unit of any given good or service that they buy will be put to a less valued use
than the one before, so we can say that they value each additional unit less and less. Because
they value each additional unit of the good less, they are willing to pay less for it. So the
more units of a good consumers buy, the less they are willing to pay in terms of the price.

By adding up all the units of a good that consumers are willing to buy at any given price we
can describe a market demand curve, which is always downward-sloping, like the one shown
in the chart below. Each point on the curve (A, B, C) reflects the quantity demanded (Q) at a
given price (P). At point A, for example, the quantity demanded is low (Q1) and the price is
high (P1). At higher prices, consumers demand less of the good, and at lower prices, they
demand more.

Factors Affecting Demand

So what does change demand? The shape and position of the demand curve can be impacted
by several factors. Rising incomes tend to increase demand for normal economic goods, as
people are willing to spend more. The availability of close substitute products that compete
with a given economic good will tend to reduce demand for that good, since they can satisfy
the same kinds of consumer wants and needs. Conversely, the availability of closely
complementary goods will tend to increase demand for an economic good, because the use of
two goods together can be even more valuable to consumers than using them separately, like
peanut butter and jelly. Other factors such as future expectations, changes in background
environmental conditions, or change in the actual or perceived quality of a good can change
the demand curve, because they alter the pattern of consumer preferences for how the good
can be used and how urgently it is needed.
Expectation to the Law of Demand
Exceptions to the Law of Demand

Note that the law of demand holds true in most cases. The price keeps fluctuating until
equilibrium is created. However, there are some exceptions to the law of demand. These
include the Giffen goods, Veblen goods, possible price changes, and essential goods. Let us
discuss these exceptions in detail.

Giffen Goods

Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods
that are inferior in comparison to luxury goods. However, the unique characteristic of Giffen
goods is that as its price increases, the demand also increases. And this feature is what makes
it an exception to the law of demand.

The Irish Potato Famine is a classic example of the Giffen goods concept. Potato is a staple in
the Irish diet. During the potato famine, when the price of potatoes increased, people spent
less on luxury foods such as meat and bought more potatoes to stick to their diet. So as the
price of potatoes increased, so did the demand, which is a complete reversal of the law of
demand.
Veblen Goods

The second exception to the law of demand is the concept of Veblen goods. Veblen Goods is
a concept that is named after the economist Thorstein Veblen, who introduced the theory of
“conspicuous consumption”. According to Veblen, there are certain goods that become more
valuable as their price increases. If a product is expensive, then its value and utility are
perceived to be more, and hence the demand for that product increases.

And this happens mostly with precious metals and stones such as gold and diamonds and
luxury cars such as Rolls-Royce. As the price of these goods increases, their demand also
increases because these products then become a status symbol.

The expectation of Price Change

In addition to Giffen and Veblen goods, another exception to the law of demand is the
expectation of price change. There are times when the price of a product increases and market
conditions are such that the product may get more expensive. In such cases, consumers may
buy more of these products before the price increases any further. Consequently, when the
price drops or may be expected to drop further, consumers might postpone the purchase to
avail the benefits of a lower price.

For instance, in recent times, the price of onions had increased to quite an extent. Consumers
started buying and storing more onions fearing further price rise, which resulted in increased
demand.

There are also times when consumers may buy and store commodities due to a fear of
shortage. Therefore, even if the price of a product increases, its associated demand may also
increase as the product may be taken off the shelf or it might cease to exist in the market.

Necessary Goods and Services

Another exception to the law of demand is necessary or basic goods. People will continue to
buy necessities such as medicines or basic staples such as sugar or salt even if the price
increases. The prices of these products do not affect their associated demand.

Change in Income

Sometimes the demand for a product may change according to the change in income. If a
household’s income increases, they may purchase more products irrespective of the increase
in their price, thereby increasing the demand for the product. Similarly, they might postpone
buying a product even if its price reduces if their income has reduced. Hence, change in a
consumer’s income pattern may also be an exception to the law of demand.

Shifts in Demand Curve

Demand curve is drawn to show the relationship between price and quantity demanded of a
commodity, assuming all other factors being constant. However, other factors are bound to
change sooner or later. A change in one of ‘other factors’ shifts the demand curve.
For example, suppose income of a consumer increases. Now, the consumer may increase the
demand for the product, even though the price has not changed. Such increase in demand of
any product, whose price has not changed, cannot be represented by the original demand
curve. It will shift the demand curve.

When the demand of a commodity changes due to change in any factor other than the own
price of the commodity, it is known as change in demand. It is expressed as a shift in the
demand curve.

Various Reasons for Shift in Demand Curve:

(i) Change in price of substitute goods

(ii) Change in price of complementary goods

(iii) Change in income of consumers

(iv) Change in tastes and preferences

(v) Expectation of change in price in future

(vi) Change in population

(vii) Change in distribution of income

(viii) Change in season and weather.

Let us understand the concept of shift in demand curve with the help of diagram.

(i) Increase in Demand is shown by rightward shift in demand curve from DD to D1D1.
Demand rises from OQ to OQ1 due to favourable change in other factors at the same price
OP.

(ii) Decrease in Demand is shown by leftward shift in demand curve from DD to D2D2.
Demand falls from OQ to OQ2 due to unfavourable change in other factors at the same price
OP.

In Fig. demand for the commodity is OQ at a price of OP. Change in other factors leads to a
rightward or leftward shift in the demand curve:

(a) Rightward Shift

When demand rises from OQ to OQ1 (known as increase in demand) at the same price of OP,
it leads to a rightward shift in demand curve from DD to D1D1.

(b) Leftward Shift

On the other hand, fall in demand from OQ to OQ2 (known as decrease in demand) at the
same price of OP, leads to a leftward shift in demand curve from DD to D2D2.
INCREASE IN DEMAND

Increase in Demand refers to a rise in the demand of a commodity caused due to any factor
other than the own price of the commodity. In this case, demand rises at the same price or
demand remains same even at higher price. For example, suppose a research reveals that
people who regularly eat green vegetables live longer. This will raise the demand for green
vegetables even at the same price and it will shift the demand curve of vegetables towards
right.

Price (Rs.) Demand (units)

20 100
20 150

As seen in the given schedule and diagram, demand rises from 100 units to 150 units at the
same price of Rs. 20, resulting in a rightward shift in the demand curve from DD to D1D1.

DECREASE IN DEMAND
Decrease in Demand refers to a fall in the demand of a commodity caused due to any factor
other than the own price of the commodity. In this case, demand falls at the same price or
demand remains same even at lower price. It leads to a leftward shift in the demand curve.

Price (Rs.) Demand (units)

20 100
20 70

As seen in given schedule and diagram, demand falls from 100 units to 70 units at same price
of Rs. 20, resulting in a leftward shift in the demand curve from DD to D1D1.

Concept of Measurement of Elasticity of

Demand
A change in the price of a commodity affects its demand. We can find the elasticity of
demand, or the degree of responsiveness of demand by comparing the percentage price
changes with the quantities demanded. In this article, we will look at the concept of elasticity
of demand and take a quick look at its various types.

Elasticity of Demand

To begin with, let’s look at the definition of the elasticity of demand: “Elasticity of demand is
the responsiveness of the quantity demanded of a commodity to changes in one of the
variables on which demand depends. In other words, it is the percentage change in quantity
demanded divided by the percentage in one of the variables on which demand depends.”

The following points highlight the top five methods used for measuring the elasticity of
demand. The methods are:

1. Price Elasticity of Demand

2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertisement or Promotional Elasticity of Sales
5. Elasticity of Price Expectations.

Method # 1. Price Elasticity of Demand

Price elasticity of demand is a measure of the responsiveness of demand to changes in the

commodity’s own price. It is the ratio of the relative change in a dependent variable (quantity
demanded) to the relative change in an independent variable (Price). In other words, price
elasticity is the ratio of a relative change in quantity demanded to a relative change in price.

Also, elasticity is the percentage change in quantity demanded divided by the percentage in
price.

Symbolically, we may rewrite the formula:

If percentages are known, the numerical value of elasticity can be calculated. The coefficient
of elasticity of demand is a pure number i.e. it stands by itself, being independent of units of
measurement. The coefficient of price elasticity of demand can be calculated with the help of
the following formula.

Where,

Q is quantity, P is price, ΔQ/Q relative change in the quantity demanded and ΔP/P Relative
change in price.

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

The price elasticity can be measured between two finite points on a demand curve (called arc
elasticity) or on a point (called point elasticity).

Method # 2. Income Elasticity of Demand

The responsiveness of quantity demanded to changes in income is called income elasticity of

demand. With income elasticity, consumer incomes vary while tastes, the commodity’s own
price, and the other prices are held constant.

The income elasticity of demand for a good or service may be calculated by the formula:
where- ey stands for the coefficient of income elasticity, Y for income.

Whereas price-elasticity of demand is always negative, income-elasticity of demand is always

positive (except for inferior goods) as the relationship between income and quantity
demanded of a product is positive. For inferior goods the income elasticity of demand is
negative because as income increases, consumers switch over to the consumption of superior
substitutes.

Method # 3. Cross Elasticity of Demand

Demand is also influenced by prices of other goods and services. The cross elasticity
measures the responsiveness of quantity demanded to changes in price of other goods and
services. Cross elasticity of demand is defined as the percentage change in quantity
demanded of one good caused by a 1 percentage change in the price of some other good.

Cross elasticity is used to classify the relationship between goods. If cross elasticity is greater
than zero, an increase in the price of y causes an increase in the quantity demanded of x, and
the two products are said to be substitutes. When the cross- elasticity is greater than zero, the
goods or services involved are classified as complements Increases in the price of y reduces
the quantity demanded of that product. Diminished demand for y causes a reduced demand
for x. Bread and butter, cars and tires, and computers and computer programs are examples of
pairs of goods that are complements.

The coefficient is positive if A and B are substitutes because the price change and the
quantity change are in the same direction. The coefficient is negative if A and B are
complements, because changes in the price of one commodity cause opposite changes in the
quantity demanded of the other. Other things such as consumer taste for both commodities,
consumer incomes and the price of the other commodity are held constant.

Method # 4. Advertisement or Promotional Elasticity of Sales

The advertisement expenditure helps in promoting sales. The impact of advertisement on

sales is not uniform at all level of total sales. The concept of advertising elasticity is
significant in determining the optimum level of advertisement outlay particularly in view of
competitive advertising by rival firms. An advertising elasticity could be defined as the
percentage change in quantity demanded for a percentage change in advertising. Advertising
might be measured by expenditure.
Advertising elasticity may be measured by the following formula:

Method # 5. Elasticity of Price Expectations

People’s price expectations also play a significant role as a determinant of demand. J.R.
Hicks, the English economist, in 1939, devised the concept of elasticity of price expectations.
The elasticity of price expectations may be defined as the ratio of the relative change in
expected future prices to the relative change in current prices.

Uses of Elasticity of Demand for

Managerial Decision Making
The concept of price elasticity of demand has important practical applications in managerial
decision-making. A business man has often to consider whether a lowering of price will lead
to an increase in the demand for his product, and if so, to what extent and whether his profits
would increase as a result thereof. Here the concept of elasticity of demand becomes crucial.

Knowledge of the nature of the elasticity of demand for his products will help a business to
decide whether he should cut his price in a particular case. Such knowledge would also help a
businessman to determine whether and to what extent the increase in costs could be passed on
to the consumer. In general for items those whose demand is elastic it will pay him to charge
relatively low prices, while on those whose demand is elastic, it would be better off with a
higher price. A monopolist would not be able to increase his price if the demand for his
product is elastic.

In practice, an accurate estimate of the probable response of volume of sales to price changes
is extremely difficult. Moreover, the cost of the statistical analysis required may in some
cases, exceed the benefit especially when uncertainty is great or when the volume is too small
to provide a reason also return on the amount spend on research. The subjective judgment of
certain managers, beyond on years of experience, sometimes exceeds in accuracy the best of
the present statistical techniques. Uses of price elasticity can be point out as below:

1. Price Distribution
A monopolist adopts a price discrimination policy only when the elasticity of demand of
different consumers or sub-markets is different. Consumers whose demand is inelastic can be
charged a higher price than those with more elastic demand.

2. Public utility pricing

In case of public utilities which are run as monopoly undertakings e.g. elasticity of water
supply railways postal services, price discrimination is generally practiced, charging higher
prices from consumers or users with inelastic demand and lower prices in case of elastic
demand.

3. Joint Supply

Certain goods, being products of the same process are jointly supplied, e.g. wool and mutton.
Here if the demand for wool is inelastic compared to the demand for mutton, a higher price
for wool can be charged with advantage.

4. Super Markets

Super-markets are a combined set of shops run by a single organization selling a wide range
of goods. They are supposed to sell commodities at lower prices than charged by shopkeepers
in the bazaar. Hence, price policy adopted is to charge slightly lower price for goods with
elastic demand.

5. Use of Machine

Workers often oppose use of machines out of fear of unemployment. Machines need not
always reduce demand for labor as this depends on price elasticity of demand for the
commodity produced. When machines reduce costs and hence price of products, if the
products demand is elastic, the demand will go up, production will have to be increased and
more workers may be employed for the product is inelastic, machines will lead to
unemployment as lower prices will not increase the demand.

6. Factor Pricing

The factors having price inelastic demand can obtain a higher price than those with elastic
demand. Workers producing products having inelastic demand can easily get their wages
raised.

7. International Trade

(a) A country benefits from exports of products as have price inelastic demand for a rise in
price and elastic demand for a fall in price. (b) The demand for imports should be inelastic for
a fall in price and elastic for a rise in price. (c) While deciding whether to devalue a country’s
currency or not, price elasticity of demand for a country’s exports would be an important
factor to be taken into consideration. If the demand is price elastic, it would lead to an
increase in the country’s exports and devaluation would fail to achieve its objective.

8. Shifting of Tax Burden

It is possible for a business to shift a commodity tax in case of inelastic demand to his
customers. But if the demand is elastic, he will have to bear the tax burden himself, otherwise
demand for his goods will go down sharply.

9. Taxation Policy

Government can easily raise tax revenue by taxing commodities which are price inelastic.