Chapter 8

DEMAND
Economists study demand in order to understand consumer behavior and the
determination of price levels, In the absence of government intervention, prices are
determined by the forces of demand and supply. Buyers and sellers are brought into
contact with one another in a market. A market does not have to be an actual location. For
example, part of the book market now exists on the Internet.

DEFINITION:-

In economics demand is not the same thing as desire, or need, or want. This is because
the strength of the desire for something will not, in itself, have any influence on the price
of the item. Only when desire is supported by the ability and willingness to pay the price
does it become an effective demand and have an influence on the market. Demand, in
economics, means effective demand and may be defined as ‘the quantity of the
commodity which will be demanded at any given price over some given period of time.’

INDIVIDUAL AND MARKET DEMAND:-

For the great majority of goods and services, experience shows that the quantity
demanded will increase as the price falls. Economists have found this out by studying
markets. It is possible to study individual demand which is the relationship between the
quantities demanded of a good or service by a single individual and the price of that good
or service. It is also possible to study market demand. This is the total demand for the
good or service. It is found by adding the quantities demanded by each individual buyer
at each price. For example one person’s demand for crisps at the current price may be
four a week and the total demand may be 30000.

Market demand will depend on how the market is defined. For example, the total demand
for all brands of crisps may be studied, or the total demand for one particular brand or the
total demand for snacks (of which crisps are a part). It is also possible to examine the
demand for crisps at different levels. For example, the demand for crisps from one
particular supermarket or in one particular area might be studied.

DEMAND SCHEDULES AND CURVES:-

Individual and market demand information can be expressed in the form of demand
schedules and demand curves. A demand schedule is a table giving the quantities
demanded at a range of prices.
A demand curve can be drawn which plots this information on a graph with price on the
vertical axis and quantity demanded at a range of prices. This is shown on Figure 8.1.

A market demand schedule and a corresponding market demand curve, can be calculated
by adding up the amounts each individual demands at different prices. This is sometimes
referred to as the horizontal summation of all the individual demand curves.
THE DEMAND CURVE:-

The demand curve shows what quantities would be demanded at any given price, if other
things do not change. These other things are discussed later in this chapter but it is
important to realize, right at the beginning, that the demand curve shows what happens to
quantity demanded when price changes and there is no change in any of the other factors
influencing demand (e.g. income, taste, fashion and so on).

Figure 8.2 shows a typical demand curve. It can be seen that at a price of P the quantity
demanded would be Q. If price fell to P’ quantity demanded would rise to QL
Alternatively, the demand curve can be used to find the maximum price consumers are
willing to pay for a given quantity For example the maximum consumers are willing to
pay for Q’ amount is P1.

In this case the demand curve also shows the price at which the good or service would be
priced out of the market. At P2 none of the good or service would be demanded. If the
good or service were to be provided free, Q2 quantity would be demanded. The areas of
the rectangles under the demand curve represent the total revenues/total expenditures
which would occur at different prices, since they are equal to price x quantity.

EXTENSIONS AND CONTRACTIONS IN DEMAND

Movements along a demand curve can be referred to as extensions and contractions in

demand or changes in quantity demanded. Figure 8.3 shows an extension in demand from
Q to Q1 as a result of a fall in price from P to P’. This can also be referred to as an
increase in the quantity demanded.

Figure 8.4 shows a contraction in demand (decrease in quantity demanded) from Q to Q’

caused by a rise in price from P to P1 It would be misleading to refer to this as a change
in demand since this term is usually applied to movements of the whole demand curve
(discussed below).
REASONS WHY DEMAND CURVES SLOPE DOWN FROM LEFT TO RIGHT
For most products demand extends as price falls. To explain this inverse relationship
economists discuss income and substitution effects and diminishing marginal utility.

INCOME AND SUBSTITUTION EFFECTS:-

When the price of a product changes, the real income of the consumer changes The
purchasing power of money income rises when the price of a product falls, it will be less
when the price rises. When the price of a product falls the tendency will be for consumers
to buy more because they can afford to buy more. Existing buyers will probably increase
their purchases and new buyers, who did not purchase at the higher price, will tend to
enter the market. This is referred to as the income effect.

A fall in the price of a product also makes it relatively cheaper when compared with
competing products. There will probably be some ‘switching’ of purchases away from the
now relatively dearer substitutes towards the product which has fallen in price.This is the
substitution effect.
Both the income and substitution effects cause consumers to buy more of a product when
it becomes cheaper Consumers become more able and more willing to buy the product.
The opposite effects will apply when the price of a product rises. Consumers’ purchasing
power will fall, reducing their ability to buy the product, and they are likely to switch to
substitute products which have become relatively cheaper
DIMINISHING MARGINAL UTILITY:-

The shape of the typical demand curve may also be explained by the action of
diminishing marginal utility. Economists define utility as the satisfaction someone gains
from the consumption of a good or service. A person buys a product because it provides
satisfaction. The more a person buys, the greater the total utility he or she will receive.
However, total utility may not rise in line with the quantity purchased.

The additional utility gained from the last unit purchased is defined as the marginal utility
of the product. For most goods and services, marginal utility diminishes as consumption
increases. For example, the first cup of tea in the morning may provide someone with a
high level of satisfaction. A second cup might also be very welcome but it is unlikely to
yield as much utility as the first, while a third cup will provide an even lower level of
satisfaction. If that person continued to consume more cups of tea on the same day a
stage would be reached where drinking tea became positively distasteful. Marginal utility
would become negative. Of course a rational person would stop consumption before that
point is reached.

Table 8.3 shows that total utility rises until six cups of tea are drunk Disutility would
occur after six cups, as marginal utility becomes negative and total utility falls. The
information can also be plated on a graph (see Figure 8.5).
MARGINAL UTILITY AND THE DEMAND CURVE:-

As rational consumers would not consume the product when marginal utility falls to zero,
the marginal utility curve would therefore in practice be as shown in Figure 8.6.This
curve may look familiar It is the basis of the demand curve. Indeed, the demand curve for
a product is the same as its marginal utility curve, measured in money terms.

Whilst utility is a subjective matter and so is difficult to measure, it can be estimated. One
way of doing this is to look at what a person is prepared to sacrifice in order to obtain a
product. Price measures this sacrifice in the sense that it indicates what other things might
have been obtained with the money. Since marginal utility diminishes, consumers will be
tempted to buy more of a good only if its price is lowered.

By assuming that the sacrifices a person is prepared to make in order to obtain something
gives an indication of the utility derived from that good, it is possible to obtain the
demand curve.

Of course different individuals will derive different levels of satisfaction and so will have
different individual demand curves. As mentioned earlier the market demand curve is
found by adding together the amount each person will demand at the different prices.
Figure 8.7 shows how the market demand curve is calculated in a simplified market
which consists of only three consumers: A, B and C.
MAXIMISING SATISFACTION:-

It is assumed that people will try to maximize their total utility (satisfaction).This is
achieved when they equate the marginal utility per penny (or any other unit of money)
they spend on the goods they buy:
This is logical. If a person could obtain more satisfaction per penny spent from good A
than from good B he or she would buy more of good A and less of good B. For example,
suppose a woman gains more satisfaction from spending money on apples than on
chocolate, taking into account their respective prices, she will probably buy more apples
and less chocolate. As she does so, the marginal utility she obtains from apples will fall
whilst the marginal utility she gains from chocolate will rise. She is likely to continue to
alter her purchases until the marginal utilities per penny spent are equal.

MARGINAL UTILITY AND CHANGES IN PRICE:-

Marginal utility explains why a change in price will cause a change in a persons spending
patterns.

Assume originally that a person divides his expenditure between steak and trout and that
he buys six steaks and four trout. Further assume that steaks cost £6 each and trout £4
each and that he gains I 2 units of marginal utility from steak and eight units from trout so
that:

Now if the price of steak rises to £8 each, the marginal utility per £ spent on steak will
fall and will be less than the marginal utility per £ spent on trout:

The consumer will then buy more trout and less steak. As he does so the marginal utility
derived from steak will rise (as he has less he will appreciate each unit more) and the
marginal utility from trout will fall until:

CONSUMER SURPLUS:-

Consumer surplus occurs when people pay less for a product than they were willing to
pay (i.e. less than the value they place on the product based on their marginal utilities).
Figure 8.8 shows an individual’s demand curve for wine.
The person would have been prepared to pay £6 for the first bottle, £5 for the second
bottle, £3.50 for the third bottle, and £2 for the fourth. If the actual price charged is £3.50,
the person will buy three bottles receiving consumer surplus of £2.50 on the first bottle, £
I .50 on the second and no consumer surplus on the third bottle. So the total consumer
surplus received is £4. The area of consumer surplus is the area under the demand curve
and above the price line.

EXCEPTIONAL DEMAND CURVES:-

As has been seen, most demand curves slope downwards from left to right. They obey the
general law that more will be demanded at lower than at higher prices. There are,
however, some unusual demand curves which show more being demanded as price rises.
This relationship is shown in Figure 8.9 where a fall in price from P to P causes a
contraction in demand from Q to Q
One type of good for which demand is exceptional is Veblen goods, named after the
American economist Torstein Veblen who coined the phrase conspicuous consumption,
i.e. people buying expensive goods and services to prove how rich they are. These can
also be called goods with ‘snob value’ or ostentatious goods. They are bought in order to
impress people. Examples may include designer label clothes and expensive watches. A
fall in their price might cause them to lose some of ‘their appeal and the quantities
demanded might fall. They will not be so effective as a means of displaying wealth.
Another category of good with exceptional demand is Giffen goods. These are named
after the Scottish economist Robert Giffen who first described the inverse relationship
which may exist between price and quantity demanded of staple foodstuffs such as
potatoes, bread, rice and corn in countries where living standards are very low. In these
countries most of people’s income is spent on basic foodstuffs. In such circumstances, an
increase in the price of the staple food could well lead to an extension in demand. This is
because if consumers’ income and the prices of other goods remained unchanged, people
would be obliged to buy at least the same quantity of potatoes, or rice, as before and they
would have less to spend on other things. The amount of money remaining for the
purchase of those extras’ to the staple diet may now buy such negligibly small amounts of
them that consumers may well decide that they would get much better value by using the
remaining income to buy more of the staple foods.

This direct relationship can also be explained by the income and substitution effects. In
the case of a Giffen good the effects work in opposite directions with the income effect
being the dominant one. If the price of a Giffen good falls there may be a tendency to
switch towards it from more expensive substitutes but the rise in purchasing power will
mean that people can now afford to buy better quality food and demand will contract.

CHANGES IN DEMAND:-

A change in demand means that one or more of the factors which determine demand
(other than the price of the product) have changed. It means that the whole demand curve
will move. An increase in demand means that more is now demanded at each and every
price. Figure 8. I 0 illustrate an increase in demand. An increased quantity is now
demanded at any given price. At the price P the quantity demanded has increased from Q
to Q’; at the price P the quantity demanded has increased from Q2 to Q3.

Figure 8. I I shows a decrease in demand. At any given price less is demanded. For
example at the price of P demand falls from Q to Q and at a price of P’ demand decreases
from Q2 to Q3.
 CAUSES OF CHANGES IN DEMAND

CHANGES IN DISPOSABLE INCOME:-

For most commodities a very important influence is the level of incomes, in particular the
level of real, disposable incomes. Disposable income is income after direct taxes have
been deducted and state benefits have been added. Real income is actual money
(nominal) income adjusted for inflation. For example if money incomes rise by 5%, but
over the same time period prices rise by I 0%, real income will have fallen and this means
that people’s ability to buy things is reduced.

Demand for most goods and services increases as real, disposable incomes rise. However
for a few goods and services demand may fall as incomes rise. These are called interior
goods and include, for example, cheaper basic foodstuffs, cheaper clothing and bus
travel.

CHANGES IN THE DISTRIBUTION OF INCOME:-

If income becomes more unevenly distributed, demand for luxury goods will increase
whilst demand for basic necessities, for example, heating and bread will decrease.

CHANGES IN THE PRICES OF RELATED GOODS AND SERVICES:-

Many goods and services have substitutes. People are influenced in their purchases by the
relative prices of competing goods and services. For example, if the price of butter fell,
the demand for margarine is likely to decrease. An increase in the fares on public
transport might increase the demand for private transport. So a change in the price of a
substitute will move the demand curves for competing goods and services.

The demand for some goods and services will be affected by changes in the prices of
complementary goods and services. Products are complementary when they are jointly
demanded the use of one requiring the use of the other The demand for videos is linked to
the demand for video recorders; the demand for petrol is associated directly with the
demand for motor cars. Thus a sharp increase in the price of motor cars might cause the
demand for petrol to fall.

CHANGES IN TASTE AND FASHION:-

The demands for some goods and services are very susceptible to changes in taste and
fashion. Particularly affected are the clothing trades, but industries producing furniture,
processed foods and beverages are also subject to movements in taste and fashion. Peer
group pressure can influence demand for products. For example, many youngsters
influenced by their friends, buy, or have bought for them, mountain bikes rather than
ordinary bikes.

ADVERTISING:-

Advertising is a powerful instrument affecting demand in many markets. Its aim, quite
clearly, is to move the product’s demand curve to the right and at the sane time move the
demand curves for competing products to the left.

THE AVAILABILITY OF CREDIT:-

If it becomes easier or cheaper to borrow, demand for a range of goods and services will
increase, for example, houses, furniture and cars

CHANGES IN POPULATION SIZE:-

An increase in population will increase demand for most goods and services.

CHANGES IN THE AGE STRUCTURE OF POPULATION:-

The UK, most of Europe, Japan, the USA and a number of other countries are currently
experiencing the development of an ageing population. They have more elderly people in
their populations and those elderly people are living longer. This results in an increase in
demand for health care, residential care and holidays specifically designed for the elderly.

WEATHER:-
Changes in weather conditions can affect demand for some goods and services. For
example, a period of hot and dry weather may increase demand for suntan lotion,
barbecues, ice creams and lager whereas it may cause a decrease in demand for heating,
umbrellas and hot drinks.