Theory of Demand
We now consider the basic theories of how the market mechanism works. In this chapter
we consider the economics of the law of demand. This is important background to
understanding the determination of prices in competitive markets.
Demand
Demand is defined as the quantity of a good or service that consumers are willing and
able to buy at a given price in a given time period. Each of us has an individual demand
for particular goods and services and the level of demand at each market price reflects
the value that consumers place on a product and their expected satisfaction gained from
purchase and consumption.
Market demand
Market demand is the sum of the individual demand for a product from each consumer
in the market. If more people enter the market and they have the ability to pay for items
on sale, then demand at each price level will rise.
Effective demand and willingness to pay
Demand in economics must be effective which means that only when a consumers' desire
to buy a product is backed up by an ability to pay for it does demand actually have an
effect on the market. Consumers must have sufficient purchasing power to have any
effect on the allocation of scarce resources. For example, what price are you willing to
pay to view a world championship boxing event and how much are you prepared to spend
to watch Premiership soccer on a pay-per-view basis? Would you be willing and able to
pay to watch Elton John perform live through a subscription channel?
Auctions of film posters
Classic film posters are fetching thousands of pounds as more and more private collectors
vie for a piece of cinema history. The prices that collectors are prepared to pay for film
posters continues to rise, some of the buyers are hoping for a financial return whereas
others are just willing and able to pay for the satisfaction that comes from owning a small
slice of cinema memorabilia.
Rockonomics – rising ticket prices for pop concerts
Tickets for the most popular rock and pop concerts keep getting more expensive but
consumers seem happy and able to pay for them judging from the number of sell-out gigs
in London this spring. The price of a seat for to see Madonna's "Confessions on a
Dancefloor" tour ranges from £80 to £160, with an additional £13 booking fee. A ticket to
see Red Hot Chili Peppers will set you back £40 and the chance to see Bruce Springsteen
at the Hammersmith Apollo is priced at just under £50 for a standard ticket. Ticket prices
have been rising much faster than the overall rate of inflation which has led to a large
rise in the real price of seeing your favourite pop star on stage.
Latent Demand
Latent demand is probably best described as the potential demand for a product. It
exists when there is willingness to buy among people for a good or service, but where
consumers lack the purchasing power to be able to afford the product. Latent demand is
affected by advertising – where the producer is seeking to influence consumer tastes and
preferences.
The concept of derived demand
The demand for a product X might be strongly linked to the demand for a related product
Y – giving rise to the idea of a derived demand.
For example, the demand for steel is strongly linked to the demand for new vehicles and
other manufactured products, so that when an economy goes into a downturn or
recession, so we would expect the demand for steel to decline likewise. The major
producer of steel in the UK is Corus. They produce for a wide range of different
industries; from agriculture, aerospace and construction industries to consumer goods
producers, packing and the transport sector. Steel is a cyclical industry which means that
the total market demand for steel is affected by changes in the economic cycle and also
by fluctuations in the exchange rate.
The demand for new bricks is derived from the demand for the final output of the construction
industry- when there is a boom in the building industry, so the market demand for bricks will increase
The Law of Demand
Other factors remaining constant (ceteris paribus) there is an inverse relationship
between the price of a good and demand.
As prices fall, we see an expansion of demand
If price rises, there will be a contraction of demand.
The ceteris paribus assumption
Understanding ceteris paribus is the key to understanding much of microeconomics. Many
factors can be said to affect demand. Economists assume all factors are held constant (ie
do not change) except one – the price of the product itself. A change in a factor being
held constant invalidates the ceteris paribus assumption
The Demand Curve
A demand curve shows the relationship between the price of an item and the quantity
demanded over a period of time. There are two reasons why more is demanded as price
falls:
The Income Effect: There is an income effect when the price of a good falls
because the consumer can maintain current consumption for less expenditure.
Provided that the good is normal, some of the resulting increase in real income is
used by consumers to buy more of this product.
The Substitution Effect: There is also a substitution effect when the price of a
good falls because the product is now relatively cheaper than an alternative item
and so some consumers switch their spending from the good in competitive
demand to this product.
The demand curve is normally drawn in textbooks as a straight line suggesting a linear
relationship between price and demand but in reality, the demand curve will be non-
linear! No business has a perfect idea of what the demand curve for a particular product
looks like, they use real-time evidence from markets to estimate the demand conditions
and they accumulated experience of market conditions gives them an advantage in
constructing demand-price relationships.
A change in the price of a good or service causes a movement along the demand curve. A
fall in the price of a good causes an expansion of demand; a rise in price causes a
contraction of demand. Many other factors can affect total demand - when these change,
the demand curve can shift. This is explained below.
Shifts in the Demand Curve Caused by Changes in the Conditions of Demand
There are two possibilities: either the demand curve shifts to the right or it shifts to the
left.
In the diagram below we see two shifts in the demand curve:
D1 – D3 would be an example of an outward shift of the demand curve (or an
increase in demand). When this happens, more is demanded at each price.
A movement from D1 – D2 would be termed an inward shift of the demand curve
(or decrease in demand). When this happens, less is demanded at each price.
The conditions of demand
The conditions of demand for a product in a market can be summarised as follows:
D = f (Pn, Pn…Pn-1, Y, T, P, E)
Where:
Pn = Price of the good itself
Pn…Pn-1 = Prices of other goods – e.g. prices of Substitutes and Complements
Y = Consumer incomes – including both the level and distribution of income
T = Tastes and preferences of consumers
P = The level and age-structure of the population
E = Price expectations of consumers for future time periods
Changing prices of a substitute good
Substitutes are goods in competitive demand and act as replacements for another
product.
For example, a rise in the price of Esso petrol should cause a substitution effect away
from Esso towards competing brands. A fall in the monthly rental charges of cable
companies or Vodafone mobile phones might cause a decrease in the demand for British
Telecom services. Consumers will tend over time to switch to the cheaper brand or
service provider. When it is easy and cheap to switch, then consumer demand will be
sensitive to price changes.
Much depends on whether consumers have sufficient information about prices for
different goods and services. One might expect that a fall in the charges from one car
rental firm such as Budget might affect the demand for car rentals from Avis Hertz or
Easycar. But searching for price information to get the best deal in the market can be
time consuming and always involves an opportunity cost. The development of the internet
has helped to increase price transparency thereby making it easier for consumers to
compare relative prices in markets.
Changing price of a complement
Two complements are said to be in joint demand. Examples include: fish and chips, DVD
players and DVDs, iron ore and steel.
A rise in the price of a complement to Good X should cause a fall in demand for X. For
example an increase in the cost of flights from London Heathrow to New York would
cause a decrease in the demand for hotel rooms in New York and also a fall in the
demand for taxi services both in London and New York.
A fall in the price of a complement to Good Y should cause an increase in demand for
Good Y. For example a reduction in the market price of computers should lead to an
increase in the demand for printers, scanners and software applications.
Change in the income of consumers
Most of the things we buy are normal goods. When an individual’s income goes up, their
ability to purchase goods and services increases, and this causes an outward shift in the
demand curve. When incomes fall there will be a decrease in the demand for most
goods.
Change in tastes and preferences
Changing tastes and preferences can have a huge effect on demand. Persuasive
advertising is designed to cause a change in tastes and preferences and thereby create an
outward shift in demand. A good example of this is the recent surge in sales of smoothies
and other fruit juice drinks.
The market for health fruit and vegetable drinks has grown rapidly in recent years
following a change in consumer preferences. How much are we influenced by the effects
of advertising?
The market demand for smoothies
The UK’s growing thirst for healthy eating and fears about the longer term health effects
of the consumption of fast food has meant that the demand for smoothies and other fresh
fruit drinks has expanded rapidly in recent years. Innocent, the leading brand in
supermarkets, estimates that the market could be worth £170m in 2007. More and more
retail outlets such as Crussh are appearing on the high streets, and demand is rising in
school canteens and workplaces. Innocent has seen its turnover expand to £37m in the
past six years and has over 50 per cent of the UK market. It sells 1m smoothies a week,
compared with 20 on its first day of operation in 1999. Some stockmarket experts are
forecasting that a fruit juice manufacturer could eventually enter the FTSE-100 list of top
stockmarket businesses.
Source: Adapted from news reports, June 2006 and the Innocent web site
Discretionary income
Discretionary income is disposable income less essential payments like electricity & gas
and, especially, mortgage repayments. An increase in interest rates often means an
increase in monthly mortgage payments reducing demand. And during 2005 and 2006 we
have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas
and electricity. This has eaten into the discretionary incomes of millions of households
across the UK. The discretionary incomes of people suffering from fuel poverty have
become a major current issue.
Interest rates and demand
Many products are bought on credit using borrowed money, thus the demand for them
may be sensitive to the rate of interest charged by the lender. Therefore if the Bank of
England decides to raise interest rates – the demand for many goods and services may
fall. Examples of “interest sensitive” products include household appliances, electronic
goods, new furniture and motor vehicles. The demand for housing is affected by changes
in mortgage interest rates.
Exceptions to the law of demand
Does the demand for a product always vary inversely with the price? There are two
possible reasons why more might be demanded even when the price of a good or service
is increasing. We consider these briefly – ostentatious consumption and the effects of
speculative demand.
(a) Ostentatious consumption
Some goods are luxurious items where satisfaction comes from knowing both the price of
the good and being able to flaunt consumption of it to other people! The demand for the
product is a direct function of its price.
A higher price may also be regarded as a reflection of product quality and some
consumers are prepared to pay this for the “snob value effect”.
Examples might include perfumes, designer clothes, and top of the range cars. Consider
the case of VI which is considered to be the most exclusive perfume in the world. Only
475 bottles have been produced and bottles have been selling for £47,500 each – a classic
case of paying through the nose for an exclusive good.
Goods of ostentatious consumption are known as Veblen Goods and they have a high-
income elasticity of demand. That is, demand rises more than proportionately to an
increase in income.
(b) Speculative Demand
The demand for a product can also be affected by speculative demand. Here, potential
buyers are interested not just in the satisfaction they may get from consuming the
product, but also the potential rise in market price leading to a capital gain or profit.
When prices are rising, speculative demand may grow, adding to the upward pressure on
prices. The speculative demand for housing and for shares might come into this category
and we have also seen, in the last few years, strong speculative demand for many of the
world’s essential commodities.
Speculation drives the prices of commodities to fresh highs
World commodity prices have reached new highs this year helped by an increase in the
rate of economic growth in the global economy. Among the metals that have achieved
record price levels are copper, zinc, gold and platinum; prompting sceptics to question
how much longer prices can continue rising. Many market experts believe that the
demand for commodities has been spurred by heavy speculator activity. For example,
pension funds and hedge funds have been investing in commodity mutual funds over
recent years leading to increased demand for precious metals. Prices have risen quickly
because commodity producers are unable to raise output sufficiently to meet
unexpectedly strong demand.
Source: Adapted from news reports, July 2006
The non-linear demand curve and the idea of price points
So far in our introductory theory of demand, we have drawn the demand curve for a
product to be linear (a straight line). In many real world markets this assumption of a
linear relationship between price and quantity demanded is not realistic. Many price-
demand relationships are non-linear and an example of this is provided in the chart
above, used to illustrate the idea of price-points.
Price points are points on the demand curve where demand is relatively high, but where a
small change in price may cause a sizeable contraction in demand leading to a loss of
total revenue for the producer.
Price points can be justified in a number of ways:
A price rise at the price point may make the product more expensive than a close
substitute causing consumers to change their preferences
Customers may have become used to paying a certain price for a type of product
and if they see a further price rise, this may cause them to revalue how much
satisfaction they get from buying and consuming something, leading to a decline in
demand
There may be psychological effects at work, supermarkets for example know the
importance of avoiding price points - £2.99 somehow seems cheaper than £3.00
despite the tiny price difference
For AS level economics, you will be expected to draw and use linear demand curves in
your basic analysis. But it is important to realise that in the real world of business, price-
demand relationships can be complex and often a business does not have enough
information about the behaviour of consumers for them to actually construct an accurate
demand curve. As with many aspects of economic theory, we are constructing curves to
illustrate economic relationships. They are simplifications of reality.
From Elasticity to Marginal Revenue
(This is a moderately technical section that may trouble those who fear math, but it logically
completes the chapter.)
Marginal revenue is the extra revenue from adding another unit of output. If a firm finds that
when it sells six units, its revenue is 24, and when it sells eight, its revenue is 28, its extra
revenue for adding two more units is four. Its marginal revenue, or the extra revenue for adding
one more unit of production, will be two.
The graph above illustrates an alternative way to compute this extra revenue. When the firm sells
six, it can charge a price of $4, but when it sells eight, it can charge only $3.50. (Thus, six units
at $4 each gives a total revenue of $24 and eight units at $3.50 each gives a total revenue of $28.)
When the firm sells the extra two units, it adds two units at $3.50 each, or $7 to its revenue.
However, it also loses something because it had to lower the price on the six units it was
previously selling. The loss is these six units times $.5 each, or $3. The net change in revenue is
$7 less $3, or $4. Equation (6) says that to get marginal revenue, the change in total revenue ($4)
must be divided by the change in output (2), which in this example gives us $2.
We have shown that marginal revenue can be computed as
(Change in Q)P + (Change in P)Q) divided by (Change in Q).
(This formula holds only approximately when changes are big, but becomes exact as the changes
get very very small. Because the change in price will be negative, the second term in the
numerator will be subtracted from the first.)
When changes in price and quantity are very, very small, the formula for price elasticity can be
written as
e = ((Change in Q)/Q) divided by ((Change in P)/P)
If your algebra is fairly good, you should be able to use these two formulas to show that the
following equation is true:
Marginal Revenue = Price (1 - 1/|elasticity|)
(Verbally, this says divide one by the absolute value of elasticity. Subtract this number from one.
Then, take this second number and multiply it by price. The result is marginal revenue.)
This last formula says that if demand is inelastic (less than one), trying to sell more will reduce
total revenue, whereas if demand is elastic (greater than one), trying to sell more will increase
total revenue. This should make intuitive sense. If people are not sensitive to price, then one
must reduce price a great deal to sell more, which means that total revenue declines.
