Intro to Demand
Demand: The quantity of a given good or service consumers are willing and able to buy at a given price.
Every person has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the expected utility we get from consuming the product.
Latent Demand: Latent demand exists when there is willingness to buy among people for a good or service, but it does not take into account whether the consumer has the purchasing power to be able to afford the product.
Effective Demand: Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it.
Market demand: The sum of all consumers’ individual effective demands
The Law of Demand: As the price of a good increases (↑), quantity demanded decreases (↓); conversely, as the price of a good decreases (↓), quantity demanded increases (↑)
The Demand Curve
The Demand Curve: A graph depicting the relationship between the price of a certain commodity (the y-axis) and the quantity of that commodity that is demanded at that price (the x-axis).
Demand curves are downward sloping due to the law of demand.
Demand as a function: Quantity demanded can be thought of as a function of price, as well as several other factors (see ‘determinants of demand’).
Qd = f(P, K1, K2, …)
The demand curve is a graphical representation of this function
Changes in Price: correspond to movements along the demand curve.
Every point on the price axis corresponds to a given point on the quantity axis.
Changes to any other determining factor: Correspond to a shift of the demand curve.
If another factor changes, the quantity demanded at all given price will change, the only way to show this is by moving the curve.
E.g. When incomes fall, people will buy fewer foreign holidays if the price stays the same.
Why is the Demand Curve Downward Sloping?
Key Question: Why do we buy less at higher prices, more at lower prices (the law of demand)?
The Income Effect: At lower price, consumers can increase their consumption for the same expenditure, meaning that the real value of their income has risen.
Provided that the good is normal (we consume more of it as we get richer), some of the resulting rise in real income will used to buy more of the product.
The Substitution Effect: At a higher price, consumers will find cheaper products more attractive and may choose to buy these instead.
When the price of a product falls however, some consumers switch their spending from an alternative as the product is now relatively cheaper.
Diminishing Marginal Utility: Marginal utility of a good or service consumed will decrease as we consume more therefore our willingness to pay falls too.
Marginal utility is the extra satisfaction (or utility) gained from consuming an additional unit of a good or service.
As we increase consumption of a good or service then our utility starts to decline, as our needs and wants become increasingly satisfied.
Question: How much would you pay for the 1st Cookie? The 2nd Cookie? …The 8th Cookie?
Determinants of Demand
Recap: Demand/the demand curve can be thought of as a function.
Quantity demanded is a function of price, as well as several other factors.
Qd = f(P, K1, K2, …)
Question: What are these factors?
1. The price of the good (p)
If the price of an ordinary G/S increases, demand for that product will decrease
If the price of an ordinary G/S decreases, demand for that product will increase
Exceptions: Products that people consume more of as the price rises and vice versa, violating the basic law of demand – i.e. upward sloping demand curves!
These goods are either ‘Veblen Goods’ or ‘Giffen Goods’ (explained later in ‘Veblen and Giffen Goods’).
2. Consumer income (y)
Most goods are ‘normal goods’, as the income of consumers increases demand for normal goods will increase
This is shown by a shift to the right of the demand curve when income rises
However, some goods are ‘inferior goods’, where demand decreases as incomes increase
This is shown by a shift to the left of the demand curve when income rises
Giffen goods are very strongly inferior (their price rise represents a fall in real income as they are such a large part of their consumers’ expenditure)
3. Prices of other goods and services
These will have a major impact on the quantity demanded of a product
Substitute products: Are those that act as an alternative for consumers
A substitute acts as an alternative, therefore creating competition. If the price of good A increases, the demand for good B will increase
Good B’s demand curve shift’s to the right
E.g. Coca-Cola and Pepsi Cola
Complementary products: Are those that are often bought together
A complement is bought alongside a good or service. If the price of good A increases, the demand for good B will decrease
Good B’s demand curve shift’s to the left
E.g. fish and chips
4. Consumer tastes or fashion
People’s tastes change over time and demand for fashionable products changes regularly, often manipulated by advertising
As some products become more fashionable there is an increase in demand
Just as quickly demand can disappear as tastes and fashion change
E.g. Fidget spinners – invented in 1993, there was a huge spike in demand in 2017 (shift right), demand has been much lower since (shifted back to the left)
5. Other factors
A variety of other factors will have an impact on the quantity demanded of a good or service including:
- Population changes
- Advertising
- The level of competition in the market
Full Demand function: Qd = f(price of the good, consumer income, price of other goods, current tastes, …)
Veblen and Giffen Goods
Breaking the law of Demand: For a small number of goods, the conventional law of demand does not hold.
This leads to an upward sloping demand curve.
As the price of one of these goods increases (↑), the quantity demanded will theoretically increase (↑)! Conversely, as the price of this good decreases (↓), quantity demanded would also decreases (↓)!
There are two different explanations for this:
Veblen Goods: Veblen goods have a ‘snob effect’ where people consume more of certain products as their price increased. This is ‘conspicuous consumption’ AKA paying for clout
E.g. Fancy cars, Supreme
Related effects include:
The common law of business balance: Low prices of a good indicates that the producer may have compromised quality, that is, “you get what you pay for”.
E.g. Cheap champagne
The hot-hand fallacy: Stock buyers have fallen prey to the fallacy that previous price increases suggest future price increases. Other rationales for buying a high-priced stock are that previous buyers who bid up the price are proof of the issue’s quality, or conversely, that an issue’s low price may be evidence of viability problems.
E.g. Bitcoin
Giffen Goods: Giffen goods are goods that are goods that tend to be very basic necessities. When the price of these goods rise, it represents a large fall in the purchasing power of consumer’s income, so they cut back on more luxurious items and double down on the very basic necessities.
Ordinary good recap: As the price rises, the substitution effect makes consumers purchase less of it, and switch to substitutes; and the income effect (due to the effective decline in available income as more is being spent on existing units of this good) reinforces this decline in demand for the good.
Giffen good explanation: A Giffen good is so strongly an inferior good in the minds of consumers (being more in demand at lower incomes) that this contrary income effect more than offsets the substitution effect, and the net effect of the good’s price rise is to increase demand for it.
E.g. (proposed): Rice and wheat/noodles in rural China, Potatoes in the Great Famine in Ireland, Kerosene in developing countries.
Joint Demand
Definition: Where the demand for two goods are interdependent.
Basically, to derive utility from one good, you need the other, and so demand both.
Compliments: In general for goods to have joint demand they both need to be strong compliments of each other.
A large and negative value of cross elasticity of demand (XED explained in elasticities section)
E.g. Razors and Razor Blades (you wouldn’t demand one without the other)
Analysis: A fall in the price of razors will lead to an increase in demand for blades.
Joint Demand Implications
Two Part pricing: A pricing strategy where companies charge a lump sum price at the initial purchase, and then a per unit charge for future/complimentary purchases.
Often this manifests in products with joint demand, where one product is (or perhaps a bundle of some amount of both) is bought in the initial purchase, and consumers then buy the second product in future.
Key Example: Gillette and disposable razor blades
In 1904, King Camp Gillette patented the first safety razor consisting of a reusable handle and replaceable blades. Initially he charged high prices for both the handle and the blades.
However, once the patent expired, and imitation products could be made, Gillette began to price the handle much lower, even so far as to make a loss on each handle sold.
By doing this, the Gillette handle was still attractively priced compared to imitators and people would often prefer it as it had built up a brand image
Where Gillette made money was in the blades, where a high price was still charged. After buying the handle customers had to continue buying blades regularly into the future.
Gillette continued to make healthy profits on the sale of blades, which more than offset the losses on handles, as people were slow to switch to alternatives that would have been cheaper in the long run
Further contemporary examples: Printers and printer ink, games consoles and games
Derived Demand
Definition: Where demand for a good or factor of production is based on the quantity traded of an intermediate good or service.
Higher trade for the intermediate good leads to higher demand for the other good too
Example: Cars and tyres
Analysis: Higher demand for cars causes greater demand for tyres.
Derived Demand for labour
Analysis: The demand for labour is derived from the quantity demanded for a firm’s output.
If demand for a firm’s output increases, the firm will demand more labour and hire more staff.
Marginal Revenue Product Theory: states that demand for labour depends upon the productivity of a worker and the marginal revenue of the goods sold. MRP = MPP * MR
MPP = Marginal physical product (the additional output an extra worker brings)
MR = Marginal Revenue of goods sold (the additional revenue that the sale of an extra unit of output brings
If demand for the good increase, the price and MR will increase leading to higher demand.
