21  Demand Analysis

21.1 Meaning of Demand

In economics, demand is not the same as desire. It is desire backed by purchasing power and the willingness to pay, expressed at a given price over a given period. Three working ideas anchor the concept (dwivedi2021?; ahuja2020?):

  • A want becomes demand only when accompanied by ability and willingness to pay.
  • Demand is always quoted at a price.
  • Demand is a flow — quantity per unit of time.

21.2 Demand Function and Determinants

The general demand function expresses quantity demanded of a good as a function of all variables that affect it:

\[ Q_x^d = f \big( P_x,\ P_y,\ Y,\ T,\ A,\ E,\ N,\ \dots \big) \]

TipDeterminants of Demand for a Good X
Determinant Effect on Q
Price of the good itself (\(P_x\)) Inverse (law of demand)
Price of related goods — substitute (\(P_y\)) Direct
Price of related goods — complement (\(P_y\)) Inverse
Income of the consumer (Y) Direct (normal); inverse (inferior)
Tastes and preferences (T) Direct
Advertising and promotion (A) Direct
Expectations of future price (E) Direct (rising expected)
Number of consumers (N) Direct
Distribution of income Depends on the good’s profile

21.3 Law of Demand

The Law of Demand states that, other things remaining the same (ceteris paribus), the quantity demanded of a good rises as its price falls and falls as its price rises. The relationship is inverse and produces a downward-sloping demand curve.

The downward slope is explained by three effects (varian2019?):

  • Income effect — at a lower price, the consumer’s real income is higher, so she can afford more of the good (and of others).
  • Substitution effect — at a lower price, the good is relatively cheaper than its substitutes; she switches into it.
  • Diminishing marginal utility — successive units yield smaller utility, so the consumer is willing to pay less for each additional unit.

21.3.1 Exceptions to the law

TipExceptions to the Law of Demand
Exception Working content
Giffen goods Inferior goods so essential to a poor household that a price rise induces more consumption (income effect dominates substitution effect). Named after Sir Robert Giffen.
Veblen / conspicuous goods Luxury goods bought for prestige; demand rises with price (Thorstein Veblen, Theory of the Leisure Class, 1899).
Speculative goods When a price rise is expected to continue, demand rises with price (stock-market behaviour).
Necessities of life Habit and necessity dampen the response.
Ignorance / quality bias Higher price taken as a signal of higher quality.

21.4 Movement vs Shift

A change in the good’s own price causes a movement along the demand curve (expansion or contraction). A change in any other determinant causes a shift of the demand curve itself (increase or decrease in demand).

flowchart LR
  M[Change in OWN<br/>price of the good] --> Mov[Movement ALONG<br/>the demand curve<br/>Expansion / Contraction]
  S[Change in OTHER<br/>determinants] --> Shf[Shift OF the<br/>demand curve<br/>Increase / Decrease]
  style Mov fill:#FFF8E1,stroke:#F9A825
  style Shf fill:#E8F5E9,stroke:#2E7D32

21.5 Types of Demand

TipTypes of Demand
Classification Categories
Source of demand Individual vs Market
Use Consumer goods vs Producer goods
Time Short-run vs Long-run
Origin Direct (final consumer) vs Derived (input demand)
Relationship Joint demand (complements) vs Composite demand (multiple uses)
Recurrence Recurring vs Replacement
Coverage Industry demand vs Firm demand
Necessity Necessities, Comforts, Luxuries

Derived demand is illustrated by the demand for cement (driven by demand for housing); joint demand is illustrated by car and tyre; composite demand is illustrated by electricity (cooking, lighting, manufacturing).

21.6 Elasticity of Demand

Elasticity of demand measures the responsiveness of quantity demanded to a change in one of its determinants. Three principal elasticities are tested.

TipThree Principal Elasticities of Demand
Elasticity Definition
Price elasticity (\(E_p\)) % change in \(Q_d\) ÷ % change in \(P\)
Income elasticity (\(E_y\)) % change in \(Q_d\) ÷ % change in income
Cross elasticity (\(E_c\)) % change in \(Q_d\) of X ÷ % change in \(P\) of Y

A fourth, advertising / promotional elasticity, measures the response of quantity to a change in advertising expenditure.

21.6.1 Price elasticity — categories and formulas

Because the demand curve slopes down, \(E_p\) is negative; convention drops the sign and reports magnitude.

TipFive Magnitudes of Price Elasticity
Magnitude Name Demand curve
\(\|E_p\| = 0\) Perfectly inelastic Vertical
\(0 < \|E_p\| < 1\) Inelastic Steep
\(\|E_p\| = 1\) Unit-elastic Rectangular hyperbola
\(1 < \|E_p\| < \infty\) Elastic Flat
\(\|E_p\| = \infty\) Perfectly elastic Horizontal

Three working methods of measurement (dwivedi2021?; ahuja2020?):

  • Percentage method: \(E_p = \dfrac{\Delta Q / Q}{\Delta P / P}\)
  • Total outlay method: if total expenditure (P × Q) rises when price falls → demand is elastic; if it falls → inelastic; if unchanged → unit-elastic.
  • Point elasticity (geometric method): at any point on a straight-line demand curve, \(E_p = \dfrac{\text{lower segment}}{\text{upper segment}}\). At the midpoint \(E_p = 1\); above midpoint \(E_p > 1\); below midpoint \(E_p < 1\).
  • Arc elasticity: average elasticity over a price range, \(E_p = \dfrac{\Delta Q}{\Delta P} \cdot \dfrac{P_1 + P_2}{Q_1 + Q_2}\).

21.6.2 Determinants of price elasticity

TipDeterminants of Price Elasticity
Determinant Effect
Number and closeness of substitutes More substitutes → more elastic
Necessity vs luxury Necessities → less elastic; luxuries → more elastic
Proportion of income spent Larger share → more elastic
Time horizon Longer time → more elastic (consumer can adjust)
Habit-forming nature Addictive → less elastic
Number of uses More uses → more elastic

21.6.3 Income elasticity

TipIncome-Elasticity Categories
Sign / magnitude Type of good Example
\(E_y > 1\) Superior / luxury Foreign holidays, premium cars
\(0 < E_y < 1\) Necessity Salt, basic clothing
\(E_y = 0\) Neutral Newspaper for many
\(E_y < 0\) Inferior Coarse grain, rural buses

21.6.4 Cross elasticity

TipCross-Elasticity Categories
Sign Relationship Example
\(E_c > 0\) Substitutes Tea and Coffee
\(E_c < 0\) Complements Car and Petrol
\(E_c = 0\) Unrelated Salt and Mobile Phones

21.7 Worked Numerical

A firm sells 1,000 units at ₹20 each. It cuts the price to ₹16 and sales rise to 1,200 units. Compute price elasticity.

% change in \(Q\) = (1,200 − 1,000) / 1,000 = 20 %. % change in \(P\) = (16 − 20) / 20 = −20 %. \(|E_p|\) = 20 / 20 = 1 — unit-elastic. The total outlay test confirms: 1,000 × 20 = ₹20,000 = 1,200 × 16 / (1,200 × 16 = ₹19,200 — close to but slightly below; minor difference owes to rounding in the percentage formula). For exam-grade rigour, the arc formula yields \(|E_p| = (200/2,200) ÷ (4/36) = 0.818\), inelastic. The exam answer is: percentage method gives unit-elastic; arc method gives slightly inelastic.

21.8 Demand Forecasting

A firm needs to know not just current demand but future demand. Forecasting methods divide into qualitative / survey and quantitative / statistical.

TipMethods of Demand Forecasting
Family Method Working
Survey Consumer-survey method (complete enumeration / sample) Direct questioning of buyers
Sales-force opinion (collective opinion) Internal estimates by sales staff
Expert opinion (Delphi method) Iterated rounds of expert estimates
Test marketing Trial launch in a controlled market
Statistical Trend projection Extrapolate past sales pattern
Barometric method Use leading indicators (e.g., construction → cement)
Regression / Econometric Estimate demand function statistically
Time-series and Box-Jenkins ARIMA models for time-series
Simulation / scenario What-if analysis

The Delphi method, developed at RAND Corporation, runs successive rounds of anonymous expert estimates with feedback after each round, converging to a consensus. The barometric method uses leading indicators — variables that move before the variable of interest. The econometric method fits a multi-variable demand function using regression and uses it to forecast.

21.9 Importance of Demand Analysis

Demand analysis underpins virtually every other decision the firm takes (mote2017?):

  • Pricing decisions — what price clears the market.
  • Production planning — how much to produce.
  • Inventory and capacity decisions — buffer for fluctuations.
  • Advertising and promotion — sensitivity of demand to marketing spend.
  • Sales planning and HR — sales-force size, talent needs.
  • Long-range planning and capital investment — when to build new capacity.

21.10 Exam-Pattern MCQs

Q 01
Which of the following is not a determinant of demand for a good X?
  • APrice of X
  • BIncome of the consumer
  • CQuantity supplied of X by producers
  • DPrice of substitutes for X
View solution
Correct Option: C
Quantity supplied is determined by supply conditions; the consumer's demand function does not include it.
Q 02
Match the type of good with its income-elasticity range:
Type Income elasticity
(i) Inferior (a) $E_y > 1$
(ii) Necessity (b) $E_y < 0$
(iii) Luxury (c) $E_y = 0$
(iv) Neutral (d) $0 < E_y < 1$
  • A(i)-(b), (ii)-(d), (iii)-(a), (iv)-(c)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(b), (iv)-(a)
  • D(i)-(d), (ii)-(a), (iii)-(c), (iv)-(b)
View solution
Correct Option: A
Q 03
The price of tea rises by 10 % and the demand for coffee rises by 5 %. The cross elasticity of demand of coffee with respect to tea is:
  • A+ 0.5; tea and coffee are substitutes
  • B− 0.5; tea and coffee are complements
  • C+ 2.0; tea and coffee are luxuries
  • D0; tea and coffee are unrelated
View solution
Correct Option: A
$E_c = +5 / +10 = +0.5$. Positive cross elasticity → substitutes.
Q 04
Match each method of measuring price elasticity with its description:
Method Description
(i) Percentage method (a) Geometric ratio of lower segment to upper segment of a straight-line demand curve
(ii) Total outlay method (b) Average elasticity over a price range
(iii) Point elasticity (c) Direct ratio of percentage change in quantity to percentage change in price
(iv) Arc elasticity (d) Demand is elastic, inelastic or unit-elastic depending on whether expenditure rises, falls or stays constant when price falls
  • A(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • B(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
  • C(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • D(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
View solution
Correct Option: A
Q 05
A "Giffen good" is best characterised as:
  • AA luxury whose demand rises with price for prestige reasons
  • BAn inferior good for which the income effect of a price rise dominates the substitution effect, so demand rises with price
  • CA speculative asset whose demand rises with expected price rise
  • DA necessity whose demand is independent of price
View solution
Correct Option: B
The Giffen paradox arises because the income effect of a price rise on an inferior good outweighs its substitution effect.
Q 06
A change in the price of a good causes:
  • AA movement along its demand curve
  • BA shift of its demand curve to the right
  • CA shift of its demand curve to the left
  • DBoth a movement and a shift simultaneously
View solution
Correct Option: A
Own-price changes → movement along; other-determinant changes → shift of the demand curve.
Q 07
Arrange the following demand-forecasting methods in order from least to most statistically rigorous: (i) Sales-force opinion (ii) Trend projection (iii) Econometric (regression-based) method (iv) Test marketing
  • A(i), (iv), (ii), (iii)
  • B(iii), (ii), (iv), (i)
  • C(ii), (iii), (i), (iv)
  • D(iv), (i), (iii), (ii)
View solution
Correct Option: A
Sales-force opinion (purely judgemental) → Test marketing (qualitative experiment) → Trend projection (single-variable statistical) → Econometric (multi-variable statistical).
Q 08
Match each elasticity with its primary determinant in business pricing:
Elasticity Determinant
(i) Price elasticity (a) Sign distinguishes substitutes from complements
(ii) Income elasticity (b) Sign distinguishes inferior from normal goods
(iii) Cross elasticity (c) Number and closeness of substitutes
(iv) Advertising elasticity (d) Responsiveness of quantity to advertising spend
  • A(i)-(c), (ii)-(b), (iii)-(a), (iv)-(d)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(d), (ii)-(c), (iii)-(b), (iv)-(a)
  • D(i)-(b), (ii)-(d), (iii)-(c), (iv)-(a)
View solution
Correct Option: A
ImportantQuick recall
  • Demand = desire backed by ability and willingness to pay at a given price over a given time.
  • Law of demand: \(Q\) ↑ when \(P\) ↓, ceteris paribus. Reasons: income effect, substitution effect, diminishing marginal utility.
  • Exceptions: Giffen, Veblen, Speculative, Necessities, Quality bias.
  • Movement = change in own price. Shift = change in any other determinant.
  • Three principal elasticities: price, income, cross. Fourth: advertising.
  • \(|E_p|\): < 1 inelastic, = 1 unit, > 1 elastic, = 0 perfectly inelastic, = ∞ perfectly elastic.
  • Methods: Percentage, Total outlay, Point (geometric), Arc.
  • Income elasticity: \(> 1\) luxury; \(0 < E_y < 1\) necessity; \(E_y < 0\) inferior; \(E_y = 0\) neutral.
  • Cross elasticity: \(> 0\) substitutes; \(< 0\) complements; \(= 0\) unrelated.
  • Forecasting methods: Survey (consumer, sales-force, Delphi, test marketing) and Statistical (trend, barometric, regression, time-series, simulation).