Demand theory (19TH CENTURY- )

First raised as a fundamental principle of microeconomics by French economist Leon Walras (1834-1910), demand theory is the analysis of the relationship between the demand for goods or services and prices or incomes.

Demand theory examines purchasing decisions of consumers and the subsequent impact on prices.

The theory was subsequently developed by English economist Alfred Marshall (1842-1924), Italian Vilfredo Pareto (1848-1923), Soviet Eugen Slutsky (1880-1948), American Kenneth Arrow (1921- ) and the French-born Gerard Debreu (1921- ).

Also see: aggregate demand theory, consumer demand theory, Slutsky’s theorem

L Walras, Elements d’economie politique pure (Lausanne, 1876);
A Marshall, Principles of Economics (London, 1890)

Factors influencing demand

Good’s own price: The basic demand relationship is between potential prices of a good and the quantities that would be purchased at those prices. Generally, the relationship is negative, meaning that an increase in price will induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of the consumer demand curve. The assumption of a negative relationship is reasonable and intuitive. For example, if the price of a gallon of milk were to rise from $5 to a price of $15, that would be a big price increase. Such a significant price increase causes the consumer to demand less of that product at the price of $15 because not only is it more expensive, but the new price is very unreasonable for a gallon of milk.Innumerable factors and circumstances affect a buyer’s willingness or ability to buy a good. Some of the common factors are:

Price of related goods: The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and gasoline. (Perfect complements behave as a single good.) If the price of the complement goes up, the quantity demanded of the other good goes down.

Mathematically, the variable representing the price of the complementary good would have a negative coefficient in the demand function. For example, Qd = a – P – Pg where Q is the quantity of automobiles demanded, P is the price of automobiles and Pg is the price of gasoline. The other main category of related goods are substitutes. Substitutes are goods that can be used in place of the primary good. The mathematical relationship between the price of the substitute and the demand for the good in question is positive. If the price of the substitute goes down the demand for the good in question goes down.

Personal Disposable Income: In most cases, the more disposable income (income after tax and receipt of benefits) a person has, the more likely that person is to buy.

Tastes or preferences: The greater the desire to own a good the more likely one is to buy the good. There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one’s desires into effect. It is assumed that tastes and preferences are relatively constant.

Consumer expectations about future prices, income and availability: If a consumer believes that the price of the good will be higher in the future, he/she is more likely to purchase the good now. If the consumer expects that his/her income will be higher in the future, the consumer may buy the good now. Availability (supply side) as well as predicted or expected availability also affects both price and demand.

Population: If the population grows this means that demand will also increase.

Nature of the good: If the good is a basic commodity, it will lead to a higher demand

This list is not exhaustive. All facts and circumstances that a buyer finds relevant to his willingness or ability to buy goods can affect demand. For example, a person caught in an unexpected storm is more likely to buy an umbrella than if the weather were bright and sunny.

The number of consumers in a market: The market demand for a good is obtained by adding individual demands of the present, as well as prospective consumers of a good at various possible prices. The larger the consumer-base is for a good, the greater the market demand for it.

Demand function and equation and curve

The demand equation is the mathematical expression of the relationship between the quantity of a good demanded and those factors that affect the willingness and ability of a consumer to buy the good. For example, Qd = f(P; Prg, Y) is a demand equation where Qd is the quantity of a good demanded, P is the price of the good, Prg is the price of a related good, and Y is income; the function on the right side of the equation is called the demand function. The semi-colon in the list of arguments in the demand function means that the variables to the right are being held constant as one plots the demand curve in (quantity, price) space. A simple example of a demand equation is Qd = 325 – P – 30Prg + 1.4Y. Here 325 is the repository of all relevant non-specified factors that affect demand for the product. P is the price of the good. The coefficient is negative in accordance with the law of demand. The related good may be either a complement or a substitute. If it is a complement, the coefficient of its price would be negative as in this example. If it is a substitute, the coefficient of its price would be positive. Income (Y), has a positive coefficient, indicating that the good is a normal good. If the coefficient were negative, the good would be an inferior good meaning that the demand for the good would fall as the consumer’s income has increased. Specifying values for the non-price determinants, Prg = 4.00 and Y = 50, results in demand equation Q = 325 – P – 30(4) +1.4(50) or Q = 275 – P. If income were to increase to 55, the new demand equation would be Q = 282 – P. Graphically, this change in a non-price determinant of demand would be reflected in an outward shift of the demand function caused by a change in the x-intercept.

Demand curve

In economics the demand curve is the graphical representation of the relationship between the price and the quantity that consumers are willing to purchase. The curve shows how the price of a commodity or service changes as the quantity demanded increases. Every point on the curve is an amount of consumer demand and the corresponding market price. The graph shows the law of demand, which states that people will buy less of something if the price goes up and vice versa.

Price elasticity of demand

Price elasticity of demand (PED) is a measure of the sensitivity of the quantity variable, Q, to changes in the price variable, P. Elasticity answers the question of the percent by which the quantity demanded will change relative to (divided by) a given percentage change in the price. For infinitesimal changes the formula for calculating PED is the absolute value of (∂Q/∂P)×(P/Q).

Elasticity along linear demand curve

The slope of a linear demand curve is constant. The elasticity of demand changes continuously as one moves down the demand curve because the ratio of price to quantity continuously falls. At the point the demand curve intersects the y-axis PED is infinitely elastic, because the variable Q appearing in the denominator of the elasticity formula is zero there. At the point the demand curve intersects the x-axis PED is zero, because the variable P appearing in the numerator of the elasticity formula is zero there.[2] At one point on the demand curve PED is unitary elastic: PED equals one. Above the point of unitary elasticity is the elastic range of the demand curve (meaning that the elasticity is greater than one). Below is the inelastic range, in which the elasticity is less than one. The decline in elasticity as one moves down the curve is due to the falling P/Q ratio.

Constant price elasticity demand

Constant elasticity of demand occurs when {\displaystyle Q=aP^{c}} where a and c are parameters, and the constant price elasticity is {\displaystyle c\leq 0.}

Perfectly inelastic demand

Perfectly inelastic demand is represented by a vertical demand curve. Under perfect price inelasticity of demand, the price has no effect on the quantity demanded. The demand for the good remains the same regardless of how low or high the price. Goods with (nearly) perfectly inelastic demand are typically goods with no substitutes. For instance, insulin is nearly perfectly inelastic. Diabetics need insulin to survive so a change in price would not effect the quantity demanded.

Market structure and the demand curve

In perfectly competitive markets the demand curve, the average revenue curve, and the marginal revenue curve all coincide and are horizontal at the market-given price.[3] The demand curve is perfectly elastic and coincides with the average and marginal revenue curves. Economic actors are price-takers. Perfectly competitive firms have zero market power; that is, they have no ability to affect the terms and conditions of exchange. A perfectly competitive firm’s decisions are limited to whether to produce and if so, how much. In less than perfectly competitive markets the demand curve is negatively sloped and there is a separate marginal revenue curve. A firm in a less than perfectly competitive market is a price-setter. The firm can decide how much to produce or what price to charge. In deciding one variable the firm is necessarily determining the other variable

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