What is Demand Analysis?

In economics, demand is described as “desire backed by adequate purchasing power”. It is defined as the amount of a commodity which a consumer is willing to purchase at a given price in a period of time. In economics, the demand for a commodity refers to both the desire to purchase the commodity as well as the ability to pay for it. Since a business would not be able to exist if there was improper demand estimate or demand forecast, hence demand analysis is one of the most important aspects of managerial economics and it is studied in great detail.

The step 1 in demand analysis begins by understanding the various types of demands which exist in the market.

Types of Demand

Demands can be categorized as follows :

1. Individual demand – This is the demand by an individual consumer. These demands include demands for clothes, shoes and other such products.
2. Household demand – This kind of demand is by a household and includes products like washing machines, refrigerators, and homes.
3. Market demand – When the demand of all the individuals and households in the market are considered, it is referred to as Market demand.

Some other types of demands are :

1. Direct demand – this kind of demand satisfies human wants directly. Examples of this demand are food and clothes.
2. Indirect demand – this kind of demand are used to produce consumers goods. Goods for production come under this kind. It is also known as Derived demand.
3. Joint demand – when more than a single commodity is required to satisfy a single need, then this kind of demand of called as Joint demand. An example here would be tea leaves, sugar, and milk – all of which are required to meet the single demand for tea.
4. Composite demand – this kind of demand is able to meet several wants at a time. Electricity, which meets the needs of several households, comes under this kind of demand.
5. Competitive demand – this kind of demand occurs when a commodity competes with its substitutes. The toothpaste of different brands have this kind of demand.

The 2nd step in demand analysis begins by understanding the factors involved in creating demand.

Factors in creating demand and Demand Analysis

Several factors affect the demand for a product or service. These factors are as follows:

1. Price of the commodity itself – This is one of the most important determinants of demand – for the individual, household as well as market demand. When the price of a product rises, demand generally falls.
2. Income of the end user – This is another important determinant of all kinds of demand. Since demand depends on the income of consumers, it rises with increasing income.
3. Taste and preferences of the end consumer
4. Price of substitute products and complementary products – Demand for a commodity changes with the price of substitute and complementary products. An example here would be a change in petrol prices can alter the demand for petrol cars.
5. Expectation about future prices of the product – if consumers expect the price of the commodity to rise in a few months, the demand for that particular commodity would increase while it would fall if there is an expectation that the price would reduce in future.
6. Advertisements – this is another important factor that affects demand. A cleverly advertised product would help increase the demand for the product while a shabby or misleading advertisement would inadvertently decrease the demand for the product.
7. Taxation policies – this again has a direct effect on the demand for a product. An example would be a rise in the income tax that citizens pay. Since this would mean less disposable income, demand for products could see a downfall.
8. Other factors such as traditions, customs, seasons, social factors and others too have an effect on the demand for a commodity.

Demand analysis formula – Demand Function

Demand function is a mathematical relationship between the quantity demanded of the commodity and its determinants. It can be represented as

Q = f ( Demand determinant)

Where Q = quantity demanded of a commodity

Demand functions are generally of two kinds. They are:

1. Individual demand function – this is the mathematical relationship between the demand by an individual consumer and the determinants of individual demand.
2. Market or aggregate demand function – this is the mathematical relationship between the market demand for a commodity and the determinants of the market demand.

Law of Demand

Law of Demand was given by Alfred Marshall and it describes a consumer’s behavior in demanding a commodity in relation to the variations in its price. The law states that other things remaining constant; the higher the price of the commodity, the lower is the demand and lower the price, higher is the quantity demanded. In other words, demand of a product varies inversely with a price when other things remain unchanged.

The conventional law of demand is given by the following formulae :

Q_x = f (P_x)

Where Q_x= Quantity demanded of commodity x

P_x= Price of the commodity x

Law of demand is generally operational due to its variations in substitution effect and income of the consumer. The following table will simplify the law of demand:

Let us now plot a graph for the above table.

As we can see, the demand curve slopes downwards from left to right. This is due to the following effects:

1. Law of Diminishing marginal utility – according to this law, as a consumer goes on buying more and more units of a commodity, its utility to him goes on decreasing. Thus, in order to get the maximum satisfaction, the consumer buys a commodity such that the marginal utility of the commodity is equal to the price of the commodity. Thus, he purchases more units when the price is lower and less quantity when the price is higher
2. Income effect – it is a commonly known fact that a price drop increases the purchasing power of consumers and vice versa. This is called an income effect.
3. Substitution effect – when the price of a goods falls while the price of its substitutes remains constant, the consumer buy more of the product.

Like everything else, the law of demand too has exceptions. These are listed below :

1. Expectations about future price
2. Veblen effect or commodity with snob appeal
3. Giffen products
4. Consumer’s psychological bias