Theory of Demand and Its Application

Dr. Muhammad Shahadat Hossain Siddiquee

Professor, Department of Economics
University of Dhaka
Contact E-mail: [email protected]
Cell: +8801719397749
The ‘Standard’ Model of Demand

• The DEPENDENT variable is the amount demanded.

• The INDEPENDENT variables are:
-the good’s own price
-the consumer’s money income
-the price of other goods
-preferences

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Demand for Tea

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Hypotheses

• Economists have hypotheses about how changes in

each independent variable affect the amount demanded
(i.e., the dependent variable).

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The Demand Curve

• The demand curve for any good shows the quantity demanded at
each price, holding constant all other determinants of
demand.
• The DEPENDENT variable is the quantity demanded.
• The INDEPENDENT variable is the good’s own price.

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The Law of Demand

• The law of demand says that a decrease in good’s own price will
result in an increase in the amount demanded, holding constant
all other determinants of demand.
• Law of demand says that demand curves are negatively
sloped.

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The Law of Demand
• The law of demand states that
there is a negative, or inverse
relationship between the
quantity of a good demanded
and its price.

• This means that demand curves

slopes downward.

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The Demand Curve

ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
QUANTITY
PRICE DEMANDED
(PER (CALLS PER
CALL) MONTH)
$ 0 30
0.50 25
3.50 7 • The demand curve is a graph illustrating
7.00 3 how much of a given product a household
10.00 1
would be willing to buy at different prices.
15.00 0

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Related Goods and Services

• Normal Goods are goods for which demand goes up

when income is higher and for which demand goes
down when income is lower.

• Inferior Goods are goods for which demand falls

when income rises.

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Related Goods and Services

• Substitutes are goods that can serve as replacements for one another;
when the price of one increases, demand for the other goes up.
Perfect substitutes are identical products.

• Complementary are goods that ‘go together’; a decrease in the price

of one results in an increase in demand for the other, and vice versa.

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Shift of Demand vs. Movement Along
a Demand Curve
• A change in demand is not the same as
a change in quantity demanded.

• In this example, a higher price causes

lower quantity demanded.

• Changes in determinants of demand,

other than price, cause a change in
demand, or a shift of the entire
demand curve, from DA to DB.

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A Change in Demand Versus a Change
in Quantity Demanded
• When demand shifts to the right, demand
increases. This causes quantity demanded
to be greater than it was prior to the shift,
for each and every price level.

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A Change in Demand Versus a Change
in Quantity Demanded
• To summarize:
Change in price of a good or service
leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).

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The Impact of a Change in Income

• Higher income decreases the demand • Higher income increases the

for an inferior good demand for a normal good

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The Impact of a Change in the Price of
Related Goods
• Demand for complement good (ketchup) shifts
left

• Demand for substitute good (chicken) shifts

right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
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From Household Demand to Market
Demand
• Assuming there are only two households in the market, market
demand is derived as follows:

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The Concept of Elasticity

• Elasticity is a measure of the responsiveness of one

variable to another.
• The greater the elasticity, the greater the
responsiveness.

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Price Elasticity

• The price elasticity of demand is the percentage

change in quantity demanded divided by the percentage
change in price.

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Price Elasticity of demand

Percentage change in quantity demanded

ED =
Percentage change in price

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Sign of Price Elasticity

• According to the law of demand, whenever the price

rises, the quantity demanded falls. Thus the price
elasticity of demand is always negative.

• Because it is always negative, economists usually state

the value without the sign.

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What Information Price Elasticity of
Demand Provides?
• Price elasticity of demand gives the exact quantity
response to a change in price.

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Classifying Demand as Elastic or
Inelastic
• Demand is elastic if the percentage change in quantity
demanded is greater than the percentage change in
price.

E>1

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Classifying Demand as Elastic or
Inelastic
• Demand is inelastic if the percentage change in
quantity demanded is less than the percentage change in
price.

E<1

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Elastic Demand

• Elastic Demand means that quantity changes by a

greater percentage than the percentage change in price.

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Inelastic Demand

• Inelastic Demand means that quantity doesn't change

much with a change in price.

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Defining Elasticities
• When price elasticity is between zero and -1 we say demand is
inelastic.

• When price elasticity is between -1 and

- infinity, we say demand is elastic.

• When price elasticity is -1, we say demand is unit elastic.

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Elasticity Is Independent of Units

• Percentages allow us to have a measure of responsiveness that is

independent of units.
• This makes comparisons of responsiveness of different goods
easier.

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Calculating Elasticity of Demand

• To determine elasticity, divide the percentage change in quantity

demanded by the percentage change in price.

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Perfectly Inelastic Demand Curve

Perfectly inelastic
demand curve

0
Quantity

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Perfectly Elastic Demand Curve

Perfectly elastic
demand curve

0
Quantity

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Demand Curve Shapes and Elasticity
• Perfectly Elastic Demand Curve
– The demand curve is horizontal, any change in price
can and will cause consumers to change their
consumption.

• Perfectly Inelastic Demand Curve

– The demand curve is vertical, the quantity demanded
is totally unresponsive to the price. Changes in price
have no effect on consumer demand.

• In between the two extreme shapes of demand curves

are the demand curves for most products.
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Determinants of the Price Elasticity of
Demand
• Price elasticity of demand depends on:
– How many substitutes there are
– How well a substitute can replace the good or
service under consideration
– The importance of the product in the consumer’s
total budget
– The time period under consideration

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Cross Elasticity of Demand

• Cross price elasticity (CPed) measures the

responsiveness of demand for good X following a
change in the price of good Y (a related good)

• CPeD = % change in qty D of product A

% change in price of product B

• With cross price elasticity we make an important

distinction between substitute products and
complementary goods and services.

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Cross Elasticity of Demand (CPed) + = Substitutes

• Substitutes:
– With substitute goods such as brands of razors, an increase
in the price of one good will lead to an increase in demand
for the rival product

– Weak substitutes – inelastic CPed

– Close substitutes – elastic CPed

Cross price elasticity will be positive for Substitutes

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Cross Elasticity of Demand (CPed) -
= Complements
• Complements:
– Goods that are in complementary demand
– Weak complements – inelastic CPed
– Close complements – elastic CPed

The cross price elasticity of demand for two

complements is negative

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Substitutes
+

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Complements -

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Goods with zero cross-price elasticity
of demand (INDEPENDENT)

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Get your calculators ready

CPeD
=
% change in qty D of product A
% change in price of product B

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Calculate the CPeD and state whether the goods are
complements or substitutes?

1. A 10% rise in the price of fish may cause demand for

chicken to increase by 2%.
2. The fall in the price of paper by 20% causes the
demand for pens to increase by 5%.
3. A 20% rise in the price of ice cream causes demand
for sweets to increase by 4%.
4. A 12% fall in the price of air fares leads to a 30% rise
in the demand for foreign holidays.
5. A 10% rise in bikes will leave the demand for cheese
unaffected.

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Answers…
• A 10% rise in the price of fish may cause demand for chicken to increase by
2%.
+2/+10 = +0.2
• The fall in the price of paper by 20% causes the demand for pens to
increase by 5%.
+5/-20 = -0.25
• A 20% rise in the price of ice cream causes demand for sweets to increase
by 4%.
+4/+20 = +0.2
• A 12% fall in the price of air fares leads to a 30% rise in the demand for
foreign holidays.
+30/-12 = -2.5
• A 10% rise in bikes will leave the demand for cheese unaffected.
0/+10 = 0

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