Lesson-6. Supply and Demand-- Demand Analysis

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1 Lesson-6 Supply and Demand-- Demand Analysis Prices influence both buyers and sellers into making economic decisions. If the price for computers goes down, it will stimulate more demand to purchase computers. If the price of corn goes up, it will stimulate farmers into producing more corn. This is how the marketplace works. This lesson will look at the market processes that influence the demand side of the equation. Introduction to Demand A market exists when buyers and sellers interact to exchange products. Supply and demand analysis describes what happens in only some of these interactions. To use supply and demand analysis, we need markets in which there are many buyers and sellers, each small relative to the overall market. Also, both buyers and sellers should be well informed, and they must form distinct and separate groups. If buyers are a group distinct from the sellers, we can analyze how they act separately from sellers. Only when we have looked at these two groups separately, we will combine them and see how they interact. What determines the amount of a product that people are willing and ready to buy during some period of time? For example, what determines the amount of hamburger purchased in Chicago during a week? Economists answer such questions by examining the costs and benefits of buying the product. When any of the costs or benefits changes, the amount of the product that people will buy should also change. The benefits a person gets from a product depend on his goals. These goals are referred to in many ways in discussions of demand. The words "tastes," "wants," "needs," "preferences" and "usefulness" all refer to goals. When people's goals change, the amount of benefit they get from the good changes, and this will cause them to change the amount of the good they want to buy.

2 Goals (or preferences or tastes) depend on many factors, such as the age of people and the amount of education they have. Social custom is an important determinant of preferences and can account for many differences in demand among groups. One can explain the large differences in squid sales in Japan and the United States, or the large differences in consumption of horse meat in Europe and the United States, almost entirely in terms of differences in preferences caused by differences in social customs. The most obvious cost a person bears in buying a product is the price of the product. Price reflects cost because people have a limited amount of funds that they can spend, and if they spend their money on one thing, they cannot spend it on another. When the price of a product goes up, the amount of other things that a person must give up in order to buy the product rises. As a result, we expect people to buy more hamburger if the price is $1.00 per pound than if it is $2.00 per pound. The amount of income a person receives affects the cost of buying an item because it determines which options a person should give up when buying a product. If a person with a low income spends $5000 for a trip around the world, he will have to cut back on food, clothing or shelter. The same trip will cause a person with a high income to cut back on a very different set of options. Increase in people's incomes raises consumption of most products. These products are called normal goods. There are some products, however, that people use less of as their income increases. These products are called inferior goods. In case of public transportation, as people's incomes rise, they stop riding the bus and drive their own cars. In the case of blue jeans, people with higher incomes bought them less frequently than people with lower incomes. It was because they were a symbol of "working class" clothes. They were adopted by the radical left in the 1960 s, and from there, they moved into high fashion. Prices of related goods also influence how much of a product people buy. Goods that are substitutes satisfy the same set of goals or preferences. An example of a substitute for hamburger is pork. If pork prices are high, people are tempted to shift away from pork to hamburger. And if pork prices are low, people are tempted to shift from hamburger to pork. The opposite of a substitute is a complement, a good that helps complete another in some way. Catsup and hamburger buns are complements to hamburger, and if they are priced low enough, consumption of hamburger may rise. Sometimes, goods are such good complements that they are sold together and we think of them as a single item. Left shoes and right shoes are an example.

3 There are other factors which influence the amount of a particular product that people are willing to buy, such as the number of consumers in the market and their expectations about future prices, incomes, and quality changes. To get a complete list for any product might be time consuming and difficult. But it is not necessary because we want to focus on the relationship between price and the quantity of a product that people are willing to buy during some interval of time. To do this, we will assume that all other factors are held constant. Demand Schedule and Demand Curve The relationship between price and the amount of a product people want to buy is what economists call the demand curve. This relationship is inverse or indirect because as price gets higher, people want less of a particular product. This inverse relationship is almost always found in studies of particular products, and its very widespread occurrence has given it a special name-- the law of demand. The word "law" in this case does not refer to a bill that the government has passed but to an observed regularity. There are various ways to express the relationship between price and quantity that people will buy. Mathematically, one can say that quantity demanded is a function of price, with other factors held constant, or: Qd = f (Price, with other factors held constant) A more elementary way to capture the relationship is in the form of a table. The numbers in the Table A below are what one expects in a demand curve-- as price goes up, the amount people are willing to buy decreases. This tabular representation is known as demand schedule (A widget is an imaginary product that some economist invented when he could not think of a real product to use in illustrating an idea). A Demand Schedule Price of Widgets $ Number of Widgets people want to buy

4 $ $ $ Table A The same information can also be plotted on a graph as shown below in Figure A. This graphical representation is known as demand curve. Figure A Law of Demand The graph above also demonstrates the law of demand. The law of demand states that as price decreases, quantity demanded increases. An inverse relationship exists. The law of demand is dependent on ceteris paribus, all other factors remaining unchanged. The following other factors are the assumptions of the law as well: 1. Price of related goods should remain unchanged. 2. Income of the consumer should not change.

5 3. Taste, preferences and fashion should not change. 4. All the units of product in question are homogeneous. In economics, the term utility refers to the measure of satisfaction received from consuming a good or service. The law of demand does not go on for infinity. There are limits. The law of diminishing marginal utility describes how the last item consumed will be less satisfying than the one before. This means, at some point, no matter how low the price is, consumers will purchase less. Change in Demand and Shift in Demand A change in quantity demanded can be illustrated by a movement between points along a stationary demand curve. Once again, demand is influenced by price. On the demand curve above, this is seen in the movement from point A to point B. A shift in demand can also occur. A shift in demand refers to an increase (rightward change) or decrease (leftward change) in the quantity demanded at each possible price. This shift is influenced by non-price determinants. An example of an increase and a decrease in demand are shown below. If one of the factors being held constant becomes unstuck, changes, and then is held constant again, the relationship between price and quantity will change. For example, suppose the price of getwids, a substitute for widgets, falls. Then, people who previously were buying widgets will reconsider their choices, and some may decide to switch to getwids. This would be true at all possible prices for widgets. These changes in the way people will behave at each price will change the demand curve to look like in the table B below. A Demand Curve Can Shift Price of Number of Widgets Widgets People Want to Buy $1.00 [100] becomes 80 $2.00 [90] becomes 70

6 $3.00 [70] becomes 50 $4.00 [40] becomes 10 Table B These are the same changes as shown in the following graph in Figure B. Figure B For all the theoretical purposes, we will assume the demand curve to be a straight line. Shift in demand can either be increase or decrease, as shown in graphs in figure C below: Increase in Demand-- It results from the increase is the price of substitute, increase in income, or change in taste and preferences etc. Decrease in Demand-- It results from the decrease in the price of substitute, decrease in income, or change in taste and preferences etc.

7 Figure C: Shift in Demand-- Increase or Decrease The most important distinction to keep in mind is that a change in quantity demanded is a movement along a single curve, while a shift in demand involves the creation of a second curve. Non-Price Determinants of Demand

8 There are other factors besides price that influence consumers to purchase products. A brief description of each is provided below. 1. A Change in Income If you receive a raise, you are likely to increase your demand for goods. If you get laid off, your demand for goods is likely to decrease. When income increases, consumers buy more. When income decreases, consumers buy less. 2. A Change in Taste Fads, fashions and the advertising of new products influence consumer decisions. Think of hula hoops and Pokeman cards craze. 3. A Change in the Price of a Substitute Good A substitute good competes with another good for consumer purchases. Examples of substitute goods include juice and soda, margarine and butter, and audio cassettes and compact discs. If the price of soda increases too much, consumers may decide to drink juice instead. 4. A Change in the Price of a Complementary Good A complementary good is jointly consumed with another good. Examples include cars and gasoline, tuition and textbooks, and milk and cereal. If the price of milk increases dramatically, consumers will decide to purchase less milk, and consequently, less cereal. 5. A Change in Buyer Expectations

9 If consumers think the price of a good will increase in future, they may decide to buy more of it now so that they pay less in future. Suppose that a storm damages a large part of the orange crop. Consumers may run out and buy all the oranges they can find in anticipation that the price of oranges will increase. 6. A Change in the Number of Buyers Population growth will increase the demand for products because the pool of consumers has grown. Population decline will have the opposite effect. Look at the baby boom generation and how they have affected demand for goods over the course of their lifetimes. A good way to end is to summarize the lesson. Demand refers to the quantities of a product that people are willing and able to purchase at a given price during some period of time. The term quantity demanded refers to a point on the demand curve-- the quantity demanded at a particular price. A demand curve can be used to illustrate the relationship between quantity demanded and price. Summary When we speak of "demand," we usually mean the entire demand relationship, i.e. the entire demand curve or table. By contrast, the "quantity demanded" is the particular point on the demand curve, as shown in figure D below, or the quantity in a particular line of the table.

10 Figure D: Demand Terminology