Theory of Demand

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

that affect demand. It is often assume that the theory of demand is the
establishment of the 'law of demand' (that the market demand is
negatively related to the price) but this is misleading in that it
concentrates on price as the sole determinant of demand,ceteris paribus.
o Demand is a multivariate relationship, that is, it is determined by many
factors simultaneously.
o Some of the most important determinants of the market demand for a
particular product are:
1. Its own price
2. Consumers' income
3. Prices of other commodities
4. Consumers' tastes
5. Income distribution
6. Total population
7. Consumers' wealth
8. Credit availability
9. Government policy
10.Past levels of demand and
11.Past levels of income.

The traditional theory of demand has concentrated on four of the above

determinants,
1. The price of the commodity
2. Other prices
3. Income and
4. Tastes.
o Some of the other factors have been introduced in the theory of demand
recently.
o It should be noted that the traditional theory of demand examines only the
final consumers' demand for durables and non-durables.
o 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.
o An important implicit assumption of the theory of demand is that firms
sell their products directly to the final consumers.
o This is not the general case in the modern business world and this has
serious implications for the determination of prices.
o 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.
 o Total demand includes final demand and intermediate demand. Final
demand is subdivided into consumers' demand and demand for
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.

THEORY OF CONSUMER BEHAVIOUR

o 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 first
examine the derivation of demand for an individual consumer.
o The consumer is assumed to be rational. Given his income and the 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.
o In the traditional theory it is assumed that the consumer has 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 'baskets of goods' which
he can buy with his income.
o There are two basic approaches to the problem of comparison of utilities,
the cardinalist approach and the ordinalist approach.
o The cardinalist school postulated that utility can be measured. Various
suggestions have been made for the measurement of utility. Under
certainty (complete knowledge of market conditions and income levels
over the planning period) some economists have suggested that utility can
be measured in monetary units, by the amount of money the consumer is
willing to sacrifice for another unit of a commodity.
o Others suggested the measurement of utility in subjective units, called
utils.
o 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. It suffices for him to
be able to rank the various 'baskets of goods' according to the
satisfaction that each bundle gives him. He must be able to determine
his order of preference among the different bundles of goods. The main
ordinal theories are the indifference-curves approach and the revealed
preference hypothesis.
 A. THE CARDINAL UTILITY THEORY

Assumptions
I. 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 the 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.
4. Diminishing marginal utility. The utility gained from successive units of a
commodity diminishes. In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it. This is the axiom of
diminishing marginal utility.

NOTE: THE CONCEPT OF SUBJECTIVE, MEASURABLE UTILITY IS ATTRIBUTED TO GOSSEN

(1854), JEVONS (1871)AND WALRAS (1874). MARSHALL (1890) ALSO ASSUMED
INDEPENDENT AND ADDITIVE UTILITIES, BUT HISPOSITION ON UTILITY IS NOT CLEAR IN
SEVERAL ASPECTS.

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
x 1, x 2 , … , xn, the total utility is
U = f(x1, X2, ... , Xn)
In very early versions of the theory of consumer behaviour it was assumed that
the total utility is additive,
U = U1(x 1) + U2(x 2) + · · · + Un(xn)
The additivity assumption was dropped in later versions of the cardinal utility
theory. Additivity implies independent utilities of the various commodities in
the bundle, an assumption clearly unrealistic, and unnecessary for the cardinal
theory.

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
(Px)· Symbolically we have
 MUx = Px

If the marginal utility of x is greater than its price, the consumer can increase his
welfare by purchasing more units of x. Similarly if the marginal utility of x is
less than its price the consumer can increase his total satisfaction by cutting
down the quantity of x and keeping more of his income unspent.
Therefore, he attains the maximisation of his utility when MUx = Px
If there are more commodities, the condition for the equilibrium of the
consumer is the equality of the ratios of the marginal utilities of the individual
commodities to their prices
MUX = MUY = MUN
PX PY PN

The utility derived from spending an additional unit of money must be the same
for all commodities. 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 others, until the above equilibrium condition is fulfilled.

Derivation of the demand of the consumer

o The derivation of demand is based on the axiom of diminishing marginal
utility. The marginal utility of commodity x may be depicted by a line
with a negative slope (figure 2.2).
o Geometrically the marginal utility of x is the slope of the total utility
function U = f(qX).
o The total utility increases, but at a decreasing rate, up to quantity
continuously, and becomes negative beyond quantity x. If the marginal
utility is measured in monetary units the demand curve for x is identical
to the positive segment of the marginal utility curve.
o At x 1 the marginal utility is MU1 (figure 2.3 ). This is equal to P., by
definition. Hence at P1 the consumer demands x1 quantity (figure 2.4).
Similarly at x2 the marginal utility is MU2 , which is equal to P2 • Hence
at P2 the consumer wiii buy x 2 , and so on. The negative section of the
MU curve does not form part of the demand curve, since negative
quantities do not make sense in economics.