Theory of Demand

The purpose of the theory of demand is to determine the various

factors that affect demand.

Demand is a multivariate relationship, that is, it is determined by

many factors simultaneously. Some of the most important
determinants of the market demand for a particular product are

 Total population
 Its own price
Consumers’ wealth
 Consumers’ income Credit availability
 Prices of other Government policy
commodities  Past levels of
demand
 Consumers’ tastes  Past levels of income 1
The traditional theory of demand has concentrated on four of the
above determinants

The price of the commodity

 Other prices
 Income
 Tastes

Some of the other factors have been introduced in the theory of demand recently.

Here we will examine the traditional Static Theory of Demand.

The traditional theory of demand examines only the final consumers’ demand for
durables and non-durables. It is partial in its approach in that it examines the
demand in one market in isolation from the conditions of demand in other markets.

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 An important implicit assumption of the theory of demand is that firms sell their
products directly to the final consumers. This is not the general case in the modern
business world, and this has serious implications for the determination of prices.

Another shortcoming of the traditional theory is that it does not deal with the
demand for investment goods, nor with the demand for intermediate products.

Consumers’
Final Demand
demand

Total demand
Demand for
Intermediate Demand investment Goods

Traditional theory of demand deals only with consumers’ demand, which is only a
fraction of the total demand in the economy as a whole. Consumer demand ranges
between 30 and 40 per cent of total demand in developed countries. 3
 Theory of Consumer Behaviour
The traditional theory of demand starts with the examination of the behaviour of the
consumer, since the market demand is assumed to be the summation of the demands
of individual consumers.

Thus we will examine the derivation of demand for an individual consumer.

The consumer is assumed to be rational. Given his income and market prices of the
various commodities, he plans the spending of his income so as to attain the highest
possible satisfaction or utility. This is the axiom of utility maximisation.

In the traditional theory it is assumed that the consumer has a full knowledge of all
the information relevant to his decision, that is he has complete knowledge of all the
available commodities, their prices and his income.

In order to attain this objective the consumer must be able to compare the utility
(satisfaction) of the various “basket of goods’ which he can buy with his income.4
There are two basic approaches to the problem of comparison of utilities.

Cardinalist Approach
 Ordinalist Approach

The Cardinalist school postulated that utility can be measured. It may be in

monetary units or in subjective units, called utils.

The Ordinalist school postulated that utility is not measurable, but is an ordinal
magnitude. The consumer need not know in specific units the utility of various
commodities to make his choice.

The main Ordinal theories are

Indifference-Curve Approach

Revealed Preference Approach 5

 The Cardinal Utility Theory

Assumptions:

1. Rationality: The consumer is rational. He aims at the maximisation of his

utility subject to the constraint imposed by his given income.

2. Cardinal Utility: The utility of each commodity is measurable. Utility is a

cardinal concept. The most convenient measure is money: the utility is
measured by the monetary units that the consumer is prepared to pay for
another unit of that commodity.

3. Constant Marginal Utility of Money: This assumption is necessary if the

monetary unit is used as the measure of utility. The essential feature of a
standard unit of measurement is that it be constant. If the marginal utility of
money changes as income increases (or decreases) the measuring-rod for
utility becomes like an elastic ruler, inappropriate for measurement.
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4. Diminishing marginal utility: The utility gained from successive units of a
commodity diminishes. In other words, marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it.

5. The total utility of a ‘basket of goods’ depends on the quantities of the individual
commodities. If there are ‘n’ commodities in the bundle with quantities
x1 , x2 , ....., xn, the total utility is

U  f ( x1 , x2 ,......, xn )
Additivity assumption was there in the very early version of the theory. This
assumption was dropped in the later versions.

Critique of this approach

 The assumption of cardinal utility is extremely doubtful

 The assumption of constant utility of money is also unrealistic.

 The axiom of diminishing marginal utility has been ‘established’ from

introspection, it is psychological law which must be taken for granted.
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 Equilibrium of the Consumer
We begin with the simple model of a single commodity ‘x’. The consumer can
either buy ‘x’ or retain his money income Y. Under these conditions the consumer
is in equilibrium when the marginal utility of ‘x’ is equated to its market
price . Symbolically we have
MU x Px
If there are more commodities, the condition for equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their
prices.

MU x / Px MU y / Py ...... MU n / Pn

This is the Equimarginal Principle. This is the fundamental condition of
maximum satisfaction.

It states that a consumer having a fixed income and facing given market prices of
goods will achieve maximum satisfaction or utility when the marginal utility of the
last dollar spent on each good is exactly the same as the marginal utility of the last
dollar spent on any other good.
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 Why must this condition hold?
If the consumer derives greater utility from any one commodity, he
can increase his welfare by spending more on that commodity and less
on the other, until the above equilibrium condition is fulfilled.

If more satisfaction could be gained by spending an additional dollar

on x rather than y, the consumer would not be maximising utility. He
could increase his satisfaction by shifting some of his expenditure
from y to x.

The common marginal utility per dollar of all commodities in

consumer equilibrium is called the marginal utility of income.

It measures the additional utility that would be gained if the consumer

could enjoy an extra dollar’s worth of consumption.

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 What are the implications of utility
maximisation?

If good A costs twice as much as good B, then buy

good A only when its marginal utility is at least
twice as great as good B’s marginal utility.

This leads to the equimarginal principle that I should

arrange my consumption so that the last dollar spent
on each good is bringing the same marginal utility.

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Derivation of the Demand Curve of the Consumer

The derivation of demand is based on the axiom of

diminishing marginal utility. Marginal utility curve will be
derived from the Total Utility curve.

Demand curve will be derived from Marginal Utility

Curve.

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 The Indifference-Curve Theory
Assumptions

Rationality: The consumer is assumed to be rational-he aims at the

maximisation of his utility, given his income and market prices. It is
assumed he has full knowledge (certainty) of all relevant information.

Utility is ordinal: It is taken as approximately true that the consumer

can rank his preferences (order the various ‘basket of goods’) according to
the satisfaction of each basket. He need not know precisely the amount of
satisfaction. It is not necessary to assume that utility is cardinally
measurable. Only ordinal measurement is required. Raking of commodities
is expressed mathematically by the consumer’s utility function.

If the utility of alternative A is 15 and the utility of b is 45, one can only say
that B is preferred to A, but it is meaningless to say that B is liked three
times as strongly as A. How much a particular bundle on the list is liked is
irrelevant; only the bundle at the top of the list will be purchased. 12
 Diminishing Marginal Rate of Substitution
(MRS)
Preferences are ranked in terms of indifference
curves, which are assumed to be convex to the
origin.

This implies that the slope of the indifference curves

increases. The slope of the indifference curve is
called the marginal rate of substitution of the
commodities.

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The total utility of the consumer depends on the quantities of the
commodities consumed.

U  f ( q1 , q2 ,..., q x , q y ,...., qn )
Consistency and Transitivity of choice: It is assumed that the
consumer is consistent in his choice, that is, if in one period he
chooses bundle A over B, he will not choose B over A in another
period if both bundles are available to him. The consistency of
assumption may be symbolically written as follows.
If A>B, then B >A
Similarly, it is assumed that consumer’s choice are characterised by
transitivity: if bundle A is preferred to B, and B is preferred to C,
then bundle A, is preferred to C. Symbolically, we may write the
transitivity assumption as follows:
If A>B, and B>C, then A>C
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 Equilibrium of the Consumer
To define this we need to introduce the concept of Indifference curves an and of
their slope, and the concept of budget line.

Indifference curve
An indifference curve is the locus of points-particular combinations of goods-which
yield the same utility (the level of satisfaction) to the consumer, so that he is
indifferent as to the particular combination he consumes.

Combinations of goods situated on an indifference curve yield the same utility.

Combinations of goods situated on a higher indifference curve yield higher level

of satisfaction and are preferred.

Combinations of goods situated on a lower indifference curve yield a lower

utility.

An indifference map shows all the indifference curves which rank the preferences
15
of the consumer.
It is assumed that the commodities y and x can substitute one another
to a certain extent but are not perfect substitute. In case of perfect
substitutes the equilibrium of the consumer may be a corner solution.

The negative of the slope of an indifference curve at any one point is

called marginal rate of substitution of the two commodities x and y
and is given by the slope of the tangent at that point.

Slope of the indifference curve= 

dy
MRS x , y
dx

The marginal rate of substitution of x for y is defined as the number

of units of commodity y that must be given up in exchange for an
extra unit of commodity x so that the consumer maintains the same
level of satisfaction.
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The concept of utility and its maximisation are void of any
sensuous connotation. The assertion that a consumer derives
more satisfaction or utility from an automobile than from a
suit of clothes means that if he were presented with the
alternatives of receiving as a gift either an automobile or a
suit of clothes, he would choose the former.

Things that are necessary for survival-such as vaccine when

a smallpox epidemic threatens- may give the consumer the
most utility, although the act of consuming such a
commodity has no pleasurable sensations connected with it.

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 Properties of the Indifference Curve

1. An indifference curve has a negative slope, which

denotes that if the quantity of one commodity (y)
decreases, the quantity of the other (x) must increase,
if the consumer is to stay on the same level of
satisfaction.

2. The further away from the origin an indifference curve

lies, the higher the level of utility it denotes: bundle of
goods on a higher indifference curve are preferred by
a rational consumer.
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 Properties of the Indifference Curve

3. Indifference curves do not intersect. It they did, the

point of their intersection would imply two different
levels of satisfaction, which is impossible.

4. The Indifference curves are convex to the origin. This

implies that the slope of an indifference curve
decreases (in absolute terms) as we move along the
curve from the left down towards the right: the
marginal rate of substitution of the commodities is
diminishing. This axiom is derived from introspection,
like the “law of diminishing marginal utility” of the
cardinalist school. 19
The axiom of decreasing marginal rate of substitution expresses the
observed behavioural rule that the number of units of x the consumer is
willing to sacrifice in order to obtain an additional unit of y increases as the
quantity of y decreases.
It becomes increasingly difficult to substitute x for y as we move along the
indifference curve.
y
The fifth unit of y can be
substituted for x by the
consumer giving up x1x2
5
of x; but to substitute
4 the second unit of y and
3 still retain the same
2 satisfaction the
1 consumer must give up a
much greater quantity
0 x x x3 x4 x of x, namely x3 x4.
1 2

20
Two Indifference
Curves
cannot
Intersect

21
22
Special Cases of Indifference Curve

23
 Derivation of the Budget Line of the
Consumer
The consumer has a given income which sets limits to his
maximising behaviour. Income acts as a constraint in the
attempt for maximising utility. The income constraint, in
case of two commodities, may be written:

Y  px qx  p y q y

We may represent the income constraint graphically by the

budget line.
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 Equilibrium of the Consumer
The consumer is in equilibrium when he maximises his
utility, given his income and the market price.

Given the Indifference map of the consumer and his budget

line, the equilibrium is defined by the point of tangency of
the budget line with the highest possible indifference curve.

At the point of tangency the slopes of the budget line and of

the indifference curve are equal.

MU x / MU y Px / Py
25
The condition shown in the previous slide is the first-order
condition. This is necessary but not the sufficient condition.
It is denoted graphically by the point of tangency of the two
relevant curves.

The second-order condition is implied by the convex shape

of the Indifference curve. This condition is fulfilled by the
axiom of diminishing MRSx,y, which states that the slope of
the indifference curve deceases (in absolute terms) as we
move along the curve from left downwards to the right.

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Graphical Derivation of Demand Curve Using Ordinal Approach

As the price of a commodity, for example of x, falls the budget line of

the consumer shifts to the right, from its initial position (AB) to a new
position (AB/), due to the increase in the purchasing power of the
given money income of the consumer. With more purchasing power
in possession the consumer can buy more of x (and more of y).

The new budget line is tangent to a higher indifference curve (e.g.

curve II).

The new equilibrium occurs to the right of the original equilibrium

(for normal goods) showing that as price falls more of the
commodity will be bought.

The diagram is given in the next slide. 27

From the price-consumption line we derive the demand curve for
commodity x.
If we allow the price
of x to fall
continuously and we
join the points of
tangency of
successive budget
lines and higher
indifference curves
we form the so-
called price-
consumption line.

Demand Curve is shown in the next slide.

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 We may plot the price
Quantity pairs defined by the
points of equilibrium
(on the price-consumption
Line) and obtain the a
Demand curve.

The demand curve for normal

Commodities will always have
a negative slope, denoting the
Law of demand, “ the quantity
Bought increases as the price
falls.

In the indifference curve approach the ‘law of demand’ is derived from what is known
as Slutsky’s Theorem which states that the substitution effect of a price change is
always negative.

The graphical implication of this theorem is shown in the next slide .

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Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d
Demand
30
Q1 Q2 Q3 Q4 Units of good X
 Price Effect (Income effect + Substitution effect)

We have seen in the previous slides that a fall in price of x from P 1 to P2 resulted in
an increase in the quantity demanded from x1 to x2.

This is the Total Price Effect which may be split into two separate effects, a
Substitution effect and an Income effect.

The substitution effect is the increase in the quantity bought as the price of the
commodity falls, after adjusting income so as to keep the real purchasing power of
the consumer the same as before.

This adjustment in income is called compensating variation and is shown

graphically by a parallel shift of the new budget line until it becomes tangent to the
initial indifference curve.

The compensating variation is a device which enables the isolation of the

substitution effect, but does not show the new equilibrium of the consumer. 31
e1 to e1/----Substitution Effect
New equilibrium is at e2. The consumer has in fact higher
purchasing power, and, if the commodity is normal, he will
spend some of his increased real income on x, thus moving
from x1/ to x2.This is income effect.
The income effect of a price change is negative for normal
goods and positive for inferior goods. Because here the change
in the purchasing power income is related with the change in
the price of x.

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For Normal goods

(Negative) Income effect + (Negative) Substitution effect= Negative Price

effect

For Inferior Goods

(Positive) Income Effect + (Negative) Substitution Effect= (Negative) Price

effect
[For most of the inferior goods the negative substitution effect will more than offset
the positive income effect]

Giffen Goods

(Positive) Income effect + (Negative) Substitution effect= (Positive) Price

effect
[Income effect is very strong. It more than offsets negative substitution effect. Here
‘law of demand’ does not hold. Giffen goods are inferior and their demand curve 33

has a positive slope]

Let’s go through an example of a Giffen good, using
potatoes and steak as the choice set of the consumer.
Imagine the consumer has a budget of $30, and the cost of a
potato begins at $0.50 and the price of a steak is $10.00.
Also consider that the consumer needs to buy meals for 10
days.

With the original budget and prices, the consumer may

choose to consume 2 steaks, at $20, and 20 potatoes for $10
over this time frame to use up their entire budget. This is a
satisfactory amount because they will have on average 2
potatoes a day, and 2 steaks over the period.

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Now imagine a price increase of potatoes to $1 each. The consumer
could still buy 2 steaks, but could now only buy 10 potatoes. This
might leave them hungry, so it is possible they will buy less steak,
and more potatoes in order to get their calories. This means that 20
potatoes will still be purchased, but now only 1 steak is purchased.

If the price of a potato increased again, say to $1.25, then the

consumer would only be able to get 16 potatoes for $20, which may
not be enough calories to survive. They will decrease their steak
consumption by one, and use that money to buy more potatoes in
order to get the necessary energy. In this example, potato
consumption would rise to 24 ($30/$1.25) and steak consumption
would drop to zero. This shows how consumption of a good would
rise with a price increase (thus an upward sloping demand curve).

35
 Law of Demand
It refers to a certain specified relationship of demand to one or more
related phenomenon which influence demand. In other words, it is
cause and effect relationship between quantity demanded and the
forces which influence this.

The law of demand can be represented by demand function which

expresses in mathematical terms the relationship of demand with one
or more other variables. Most important normally in this is the price of
the product. Using this mathematical relationship between demand
and price of a specific product we can derive a schedule of demand
which can also be presented on a graph paper.

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 Behaviour Pattern of Demand

(i) The relationship of quantity demanded to price of the product is

one of an inverse nature so that the quantity demanded increases
with decrease in price and the vice versa is also true.

(ii) When the demand is related with the income the relationship is
direct so that demand increases with increase in income and
decreases with decrease in income. However the trend of
increase or decrease may depend on the nature of the product. It
may increase rapidly if the commodity is of superior type but the
demand for essentials may not increase at the rate at which the
income increases.

37
(iii) The demand for a product is directly related with the price of a
substitute but it is inversely related with the price of a
complementary product. In other words, in case of a rise in price
of a substitute the demand curve will be upward rising and in
the other case it will be falling downwards.

(iv) The behaviour of demand would also depend upon the

commodity considered. For example, the demand for food will
increase directly with the growth of population. Similarly, it will
increase directly with marketing effort.

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 Exception to the Law of Demand

(i) The demand for goods which are in nature of conspicuous

consumption is not inversely related with price. It may go up
with a high price.

(ii) The demand is guided by the demonstration effect of the

consumption pattern of a social group to which the person
belongs. It is generally not related with the utility to the
individual because it is used just to demonstrate that person is
not inferior to others in the group.

(iii) Future expectations about price and ability may affect behaviour
pattern which is against the normal law of demand.

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(iv) The nature of product has considerable effect on demand of
certain goods in relation to changes in income. The Giffen effect
shows how with increase in price of both bread and butter the
demand for bread increased but of the butter came down because
of substitution of bread for butter. Giffen goods are inferior and
their demand curve has a positive slope. Giffen goods are rare in
practice.

(v) The effect of various forces on demand specially on producer’s

goods and that of consumer durables would depend upon the
existing stock of goods and the level of utilisation.

(vi) At times there are impulsive purchases without any cool

calculations about price and usefulness of the product and in
such contexts the law of demand fails.
40
 The Revealed Preference Hypothesis
Samuelson introduced the term “revealed preference into
economics in 1938. Since then the literature in this field
has proliferated.

This hypothesis is considered as a major breakthrough in

the theory of demand, because it has made possible the
establish of ‘the law of demand’ directly ( on the basis of
revealed preference axioms) without the use of indifference
curves and all their restrictive assumptions.

41
Regarding the ordering of consumers’ preference, the
revealed preference hypothesis has advantage over the
Hicks-Allen approach of establishing the existence and the
convexity of the indifference curves (it does not accept
them axiomatically)

However, the indifference curves are redundant in the

derivation of the demand curve.

We will first examine the derivation of the ‘law of

demand’. Secondly, we will show how indifference curves
can be established.

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 Assumptions:
1. Rationality
The consumer is assumed to behave rationally, in that he
prefers bundles of goods that include more quantities of the
commodities.

2. Consistency
The consumer behaves consistently, that is, if he chooses
bundle A in a situation in which bundle B was also available
to him he will not choose B in other situation in which A is
also available.
If A>B, then B >A
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3. Transitivity
If in any particular situation
A>B, and B>C, then A>C

4. The revealed preference axioms

The consumer, by choosing a collection of goods in any one budget
situation, reveals his preference for that particular collection. The
chosen bundle is revealed to be preferred among all the alternative
bundles under the budget constraint. The chosen ‘basket of goods’
maximises the utility of the consumer. The revealed preference for a
particular collection of goods implies (axiomatically) the
maximisation of the utility of the consumer.
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Assume that the
consumer has the
budget line AB in the
figure and chooses
the collection of goods
denoted by point Z,
thus revealing the
preference for this
batch.

Suppose that the

price of x falls so that
new budget line
facing the consumer
is AC. We will show
that new batch will
include a larger
quantity of x.
45
Firstly, we make a ‘compensating
variation’ of the income, which
consists in the reduction of income
so that consumer has just enough
income to enable him to continue
purchasing Z if he so wishes.

46