Theories of Demand (Demand Function and Law of Demand) and Indifference Curve Approach | Economics

Understanding how consumers make choices is central to microeconomics. The theories of demand provide the framework for analysing how individuals decide which goods and services to purchase, based on their preferences, income, and the prices of commodities.

Demand

Demand refers to the quantity of a goods or services that consumers are willing and able to purchase at a given price over a specific period of time.

According to Benham, “the demand for anything at a given price is the amount of it, which will be bought per unit of time at that price.”

Law of Demand

The law of demand simply expresses the relation between quantity of a commodity demanded and its price. It states the inverse relationship between the price and quantity demanded of a commodity; as the price of a good increases, the quantity demanded falls; conversely, as the price decreases, the quantity demanded rises.

According to Law of Demand, “all other things being equal, the quantity demanded of a good or service decreases as its price increases, and vice versa.” In simpler terms, people tend to buy less of something when its price goes up and more when its price goes down. 

Law of Demand, as described by some eminent economists:

1. According to Bilas, “the law of demand states that other things being equal, the quantity demanded per unit of time will be grater, lower the price and smaller, higher the price.”
2. According to Marshall, “the amount demanded increases with a fall in price and diminishes with a rise in price.”
3. According to Professor Samuelson, “law of demand states that people will buy more at lower prices and buy less at higher prices, other things being constant.”
4. According to Ferguson, “according to law of demand, the quantity demanded varies inversely with price.”

Assumption of Law of Demand:

Some assumptions related to the Law of Demand are as follows: - 

1. No Change in Tastes and Preferences - If consumers suddenly develop a stronger preference for a product (due to a trend, health report, or advertising), they will buy more of it at the same price. By assuming tastes remain constant, we ensure that a change in quantity is driven solely by a change in the price tag, not a change in consumer sentiment.
2. Constant Conusmer Income - A consumer’s ability to pay is tied to their income. If income rises, a consumer might buy more of a good even if the price remains high. To observe the effect of price changes alone, we assume income remains fixed.
3. Prices of Related Commodities Stay the Same - This refers to substitutes (e.g., tea vs. coffee) and complements (e.g., printers vs. ink). If the price of a substitute changes, consumers will switch to that product regardless of the original good's price. Holding these prices constant allows us to observe the Law of Demand in isolation.
4. No Change in the Wealth of Consumers - While similar to income, wealth includes accumulated assets. A sudden change in wealth (like a stock market crash or windfall) can significantly alter purchasing power. Assuming wealth remains stable prevents external financial shocks from interfering with the price-demand relationship.
5. No Substitutes are Discovered - If a new, superior technology or alternative is introduced to the market, demand for the existing product may reduce regardless of its price. Assuming no new substitutes emerge ensures that the current product's competitive landscape remains unchanged during the analysis.

When any of these factors, like income or tastes change, the entire demand curve shifts. When only the price changes, we see a movement along the existing curve.

Importance of Law of Demand:

The law of demand is not limited to theory itself; it extends beyond. It is as crucial for policymakers, businesses, and individuals.

1. Price Determination in Perfect Competition - In a perfectly competitive market, individual firms have no control over the price; they are "price takers." The market price is determined by the intersection of the Market Demand curve (which slopes downward due to the Law of Demand) and the Market Supply curve (which slopes upward). Because the Law of Demand ensures the market demand curve is downward-sloping, it allows for a stable equilibrium point where quantity demanded equals quantity supplied. Without this law, the market would lack the predictive mechanism to find an equilibrium price where shortages or surpluses are eliminated.
2. Tax Imposition - Governments use the Law of Demand and the concept of Price Elasticity of Demand to predict the outcomes of fiscal policy, specifically regarding the incidence of taxation. When a tax is imposed on a good, the price for the consumer increases. The Law of Demand allows policymakers to predict how much consumers will reduce their consumption in response. If demand is inelastic (consumers continue to buy despite price hikes), the tax generates stable revenue. If demand is elastic (consumers switch to alternatives), the tax may lead to a significant drop in sales.
3. Planning for Individual Purchase of Commodities - For an individual consumer, the Law of Demand serves as a guide for rational decision-making and budget allocation. Individuals operate with finite resources (income). By understanding that price changes influence quantity demanded, consumers can optimize their utility. For example, if the price of a preferred good rises, the Law of Demand helps the consumer recognize the need to substitute it with a cheaper alternative or adjust their consumption level to maintain their standard of living within their budget constraints.
4. Planning of Industries Regarding Production of Output - Businesses rely heavily on demand forecasting to manage their operations, inventory, and long-term production capacity. Industries use the Law of Demand to estimate how changes in their product's price or changes in external factors (like consumer income or competitor prices) will affect the volume of goods they can sell. If a company plans to expand production, it must ensure that there is sufficient market demand at the proposed price point to avoid overproduction, which leads to excess inventory, storage costs, and lost profitability. Essentially, the Law of Demand acts as a constraint that forces firms to align their production levels with the reality of consumer willingness to pay.

Exceptions / Limitations of Law of Demand:

Some exceptions of Law of Demand are as follows: -

1. Giffin Goods / Special Type of Inferior Goods – Sir Giffin pointed out that Law of Demand does not apply to inferior goods. This is called Giffin Paradox. Inferior Goods refer to those goods whose demand decrease with an increase in income. Eg.: toned milk and full cream milk; bread and meat.
2. Veblen Effect / Articles of Distinction – There are some commodities which are purchased by the upper section of the society. If the price of such commodities is increasing, then there will be more demand for them. Eg.: antique items, artistic goods, diamonds etc.
3. Fear of Shortage – When there is fear of shortage due to a war like situation or an emergency, people buy more of a commodity given at a higher price, due to panic situation.
4. Expectation of Change in Price in Future / Speculative Effect – If people expect a rise in price in future, they will rush to purchase more of the commodity at present price. If they expect the price to fall, they will purchase less of the commodity to enjoy benefit from the fall in price later.
5. Ignorance on the Part of Consumers About Quality – A lower price commodity may be considered inferior and people buy lesser amount of it. But when its price is more, they consider it to be superior and purchase more.
6. Necessities of Life – In case of basic necessities like food items, medicines, water, clothes etc., people purchase the same quantity even at a high price.

Demand Schedule

A demand schedule is a table that shows the quantity of a good or service that consumers are willing and able to buy at different prices during a certain time period. Law of Demand is represented through Demand Schedules. They summarise the information on prices and quantity demanded.

Types of Demand Schedule:

The Demand Schedule can be of two types: -

1. Individual Demand Schedule – It refers to the price and amount demanded of a commodity by an individual.
2. Market Demand Schedule – It shows the total quantity demanded that all the consumers in the market are willing and able to buy at all possible prices and, at a given amount of time.

Sample Demand Schedule:

Demand Curve

If we show the demand schedule graphically, we get the demand curve. The Demand Curve shows the maximum quantities per unit of time that consumers will take at various prices. The Demand Curve slopes downward from left to right.

According to RG Lipsey, “this curve, which shows the relation between the price of a commodity and the amount of that commodity the consumers wishes to purchase, is called Demand Curve.”

Reasons for Downward Sloping of The Demand Curve (Left to Right):

1. Diminishing Marginal Utility – The Law of Diminishing Marginal Utility states that as a consumer acquires more units of a specific commodity, the satisfaction (utility) derived from each additional unit decreases. Since the consumer is only willing to pay a price that reflects the marginal utility of the good, they will only purchase additional units if the price falls to match that lower utility. Therefore, as price decreases, the quantity demanded increases to equate marginal utility with the new, lower price.
2. New Consumers (Market Entry) – At higher prices, only consumers with higher purchasing power can afford or justify buying a product. When the price falls, the commodity becomes accessible to a the masses,those who were previously "priced out" of the market. This influx of new buyers shifts the total quantity demanded in the market upward.
3. Income Effect – The income effect refers to the change in a consumer's "real income" (purchasing power) caused by a change in the price of a good. When the price of a commodity falls, the consumer can purchase the same quantity of the good while spending less money. This surplus in real purchasing power allows them to either buy more of that same good or other goods, effectively increasing the quantity demanded.
4. Substitution Effect – This occurs when a change in the price of one good makes it relatively cheaper or more expensive compared to its substitutes. If the price of Good A falls while the price of its substitute, Good B, remains constant, Good A becomes the more attractive choice. Consumers will naturally switch (substitute) away from the relatively more expensive Good B toward the cheaper Good A, thereby increasing the quantity demanded for the latter.
5. Different Uses of the Commodity (Composite Demand) – Many commodities have "composite demand," meaning they can be used for multiple purposes. For example, electricity can be used for basic lighting (high priority) or for running non-essential appliances like air conditioning (lower priority). If the price of electricity is high, it is used only for essential needs. If the price falls, it becomes economical to use it for secondary, less urgent purposes as well, which leads to an increase in total market demand.

Demand Function

A demand function is a mathematical representation of the relationship between the quantity of a good or service that consumers are willing and able to buy (quantity demanded) and the various factors that influence that quantity. 

These factors, known as determinants of demand, include the price of the good, consumer income, prices of related goods, consumer tastes and preferences, and expectations about future prices.

The effect of all factors of demand on the amount demanded for the commodity is called Demand Function.

Demand Function: D(x) = f (Px, Py, I, T, W)

• D(x) = demand of the commodity x
• Px = price of the commodity x
• Py = price of other commodities
• I = income
• T = Tastes and Preferences
• W = wealth of the consumer

When other things remain constant, demand depends on the price of the commodity.

D(x) = f (Px) [simple form].

This demand function is considered as the law of demand.

Factors Affecting Demand / Causes of Change in Demand

Factors affecting demand are as follows: 

1. Price of the Commodity – This follows the Law of Demand. When price is the only variable changing, economists assume ceteris paribus (all other things held constant). As the price increases, the opportunity cost of purchasing the item rises, leading to a decrease in quantity demanded. This represents a movement along the existing demand curve, not a shift of the curve itself.
2. Income of the Consumer – For Normal Goods (like branded clothing or electronics), demand rises as income rises. However, it is worth noting the existence of Inferior Goods (like generic bus passes or low-quality staple foods), where demand actually falls as income rises because consumers switch to higher-quality alternatives.
3. Price of Related Goods – In case of substitutes, for instance tea and coffee, when coffee becomes cheaper, the consumer substitutes coffee for tea. As a result, the demand for coffee increases, and that of tea decreases. In case of complimentary goods, rise in demand for one leads to rise in demand for the other. For instance, car and petrol, when demand for car increases, the demand for petrol also increases.
4. Taste and Preferences of the Consumer – These factors are subjective and shift the demand curve regardless of price. Cultural trends, health consciousness, or social status can make a product more or less desirable. For example, the shift toward SUVs represents a change in societal preference, where consumers are willing to pay more for utility and perceived status, effectively increasing demand at any given price point.
5. Advertisements – In the era of modern civilisation, advertisements in TV, radio, newspaper etc. influences the demand for the product and even can change demand pattern of the consumers. Advertising acts as a catalyst to influence consumer perception. It informs consumers about product existence (increasing demand) or attempts to differentiate a product from competitors. Successful advertising effectively shifts the demand curve to the right by creating brand loyalty or perceived necessity.
6. Consumer expectations – This is based on "anticipatory behavior." If consumers anticipate that a future event (like a festive sale or a predicted shortage) will alter the price, they adjust their current consumption. If they expect prices to rise next month, they will buy now, increasing current demand.

Changes in Demand

The demand curve shows the inverse relationship between price and quantity demanded, i.e., how the various quantities of a commodity can be sold at different prices assuming other things constant. The effect of change in demand consequent to changes in other things is called “shift in demand schedule.” If the shift is towards right, it is called increase in demand and when there is leftward shift in demand curve, it is called decrease in demand.

Since here price is not the sole factor in determining demand, but changes in other things are equally important. Therefore, in increase and decrease in demand, we keep price as a constant factor and we take other things (income of consumers, shares and debentures) into consideration. On the other hand, if the changes arise due to change in price, it is called expansion and contraction in demand.

Different Kind of Changes in Demand:

1. Increase in Demand
2. Decrease in Demand
3. Extension of Demand
4. Contraction of Demand

Difference between Increase in Demand and Decrease in Demand:

Difference between Extension of Demand and Contraction of Demand:

Difference between Extension of Demand and Increase in Demand:

Difference between Contraction of Demand and Decrease in Demand:

Note: - in all the differentiations above, do make diagram of each (increase, decrease, extension, contraction) in each distinction, depicting their movement.

Indifference Curve Approach

Indiference Curve (IC) is a diagrammatic representation of different sets/combinations of two commodities yielding the same level of satisfaction to the consumer. For eg.: apples and oranges.

Each point on the IC indicates one combination of two goods.

Properties of Indifference Curve:

1. Slopes Downward from Left to Right - An indifference curve must slope downward because of the principle of negative slope. To maintain the same level of satisfaction, if a consumer chooses to acquire more of "Good X," they must be willing to give up some amount of "Good Y." If the curve sloped upward, it would imply that a consumer could have more of both goods, which would result in a higher level of satisfaction, contradicting the definition of an indifference curve.
2. Convex to the Origin; IC Tends to Decline (Diminishing MRS) - This property indicates the Diminishing Marginal Rate of Substitution (MRSxy). As a consumer has more of "Good X," they are willing to give up less and less of "Good Y" to get an additional unit of "Good X." The curve bends inward toward the origin because the consumer places a lower value on additional units of a good as they consume more of it.
3. Higher IC Gives Higher Satisfaction - This follows the principle of unvarying preferences, which assumes that consumers prefer more goods to fewer (assuming the goods are "desirable"). Any bundle on a higher indifference curve (further from the origin) contains more of at least one good (or both) compared to a bundle on a lower curve, providing greater utility.
4. IC Never Touches the  ‘x’ and ‘y’ Axis - Standard indifference curve models assume that a consumer is considering bundles that contain both goods. If a curve touched an axis, it would imply the consumer is deriving utility from a bundle consisting of zero units of one of the goods (e.g., consumption of only X and zero Y). While mathematically possible in some models, the standard "well-behaved" indifference curve is drawn not to touch the axes to reflect the assumption that consumers prefer variety.
5. 2 IC Never Intersect Each Other - If two indifference curves were to intersect, it would violate the Transitivity Axiom of consumer preferences. If point A is on both curves, and B and C are points on the respective curves, the intersection would imply that the consumer is indifferent between bundles that provide different levels of utility. This creates a logical paradox, as a rational consumer cannot be indifferent between two baskets that provide different amounts of satisfaction.