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--THE LAW OF DEMAND--
--THE LAW OF DEMAND--
--INTRODUCTION--
In unit 1.1 we read that in a FREE MARKET SYSTEM, WHAT TO PRODUCE, is determined by CONSUMERS who guide producers about how to allocate their productive resources through their DEMAND and WILLINGNESS TO PAY, so now let's learn about the concept of DEMAND.
--DEFINITION: DEMAND--
DEMAND refers to the amount of a good or service that is demanded at each price level
EFFECTIVE DEMAND refers to demand from consumers who possess the WILLINGNESS and ABILITY (In terms of income) to purchase a good or service.
If we return to the circular flow model we see that HOUSEHOLDS use their INCOMES to SPEND on the GOODS and SERVICES produced by FIRMS. This presupposes that FIRMS make products that HOUSEHOLDS actually want or in other words the products that they DEMAND.
DEMAND, therefore, guides the decisions of the owners of the factors of production regarding how they allocate their resources.
--DEFINITION: LAW OF DEMAND--
THE LAW OF DEMAND refers to a law stating that there is a NEGATIVE RELATIONSHIP between price (P) and quantity (Q) of a good demanded:
"THE HIGHER (LOWER) THE PRICE, THE LOWER (HIGHER) THE QUANTITY DEMANDED, CETERIS PARIBUS."
--THE DEMAND CURVE--
--THE DEMAND CURVE--
--DEMAND CURVE:--
If we plot the relationship between PRICE and QUANTITY DEMANDED according to the law of demand we can derive a 'DEMAND CURVE'.
INDIVIDUAL DEMAND refers to the quantity that a single consumer is willing and able to buy at each price level
MARKET DEMAND refers to the summation of all individual demand curves for an IDENTICAL PRODUCT.
--INDIVIDUAL & MARKET DEMAND--
--INDIVIDUAL & MARKET DEMAND--
--INDIVIDUAL & MARKET DEMAND--
The individual demand curve is derived from the individual's diminishing marginal utility curve. As such the MARKET DEMAND curve is DERIVED FROM the SUMMATION of the INDIVIDUAL DEMAND or marginal utility curves.
We can see below that we can derive a MARKET DEMAND CURVE, from 3 INDIVIDUAL DEMAND CURVES.
--TASK--
--Let's create a class demand curve for slices of pizza!--
Open this google sheet BELOW
Chose one of the columns and type your name at the top.
Now, enter the price you would be willing to pay for the 1st slice ($0-$10) in the '1st' row
Next, enter the price you would be willing to pay for the 2nd slice in the '2nd' row
and so on....
...If you aren't willing to pay for extra slices just enter $0.
Does this curve follow the LAW of DEMAND?
What impacted your willingness and ability to pay for pizza?
Wllingness to pay curve => demand curve.xlsx--TASK: THINK ALOUD--
What impacted your willingness and ability to pay for pizza?
Did you think about the income you earn?
Did you think about the price of substitutes?
Did you think about the amount of satisfaction you receive?
--ASSUMPTION OF LAW (HL)--
--REASON#1: 'THE INCOME EFFECT'--
If we assume INCOMES ARE FIXED, a DECREASE IN PRICE will INCREASE the 'PURCHASING POWER' of the income (and vice-versa), allowing EXISTING CONSUMERS TO BUY MORE, as well as entice NEW CUSTOMERS to purchase the more affordable product.
For example, with an income of $100 and Coke priced at $10 per bottle, a consumer may have been willing to purchase 10 bottles, now if the price dropped to $5 per bottle, they are now able to afford 20 bottles ($100/$5), with the same income, and thus may purchase more.
So we can say that AS PRICE FALLS (RISES), THE QUANTITY DEMANDED RISES (FALLS)
--REASON#2: 'THE SUBSTITUTION EFFECT'--
If we assume THE PRICE OF ALL SUBSTITUTES STAYS FIXED, then a fall in the price of a good with a very close substitute will not only benefit from the 'income effect', but also, they will be ABLE TO ATTRACT CUSTOMERS AWAY FROM THEIR RIVAL who is now comparatively more expensive.
For example, if PEPSI was to lower its price relative to COKE, then COKE drinkers may switch to PEPSI instead, hence demand will grow because of the substitution effect. How realistic do you think this scenario is?
So AGAIN we can say that AS PRICE FALLS (RISES), THE QUANTITY DEMANDED RISES (FALLS)
--REASON#3: 'LAW OF DIMINISHING MARGINAL UTILITY'--
According to the LAW OF DIMINISHING MARGINAL UTILITY, the MARGINAL BENEFIT (UTILITY) that a consumer derives from consuming each additional unit of a good GETS PROGRESSIVELY LOWER for EACH ADDITIONAL UNIT CONSUMED. Now if marginal utility is expressed in a monetary form, we can say that the greater the quantity consumed the lower the marginal utility and the less the rational consumer would be prepared to pay, in other words, THE PRICE A CONSUMER IS WILLING TO PAY GETS PROGRESSIVELY LOWER for EACH ADDITIONAL UNIT.
Therefore we can say that there is an INVERSE RELATIONSHIP between the quantity consumed and the willingness to pay (marginal benefit). In other words, as MORE IS CONSUMED, THE WILLINGNESS TO PAY FALLS...
This follows the law of demand, which states that 'MORE IS DEMANDED WHEN PRICE FALLS.
We can see below that the individual's demand curve is derived from the individual's diminishing marginal benefit.
When the price is $10 he is only willing to consume the first cup, hence when P = $10, Qd = 1
When the price is set at $6 he will definitely buy the 1st cup as he was willing to pay $10, but now he is also willing to buy a 2nd cup, hence at P = $6, Qd is 2.
When the price is set at $2 he will definitely buy the 1st and 2nd cups as he was willing to pay $10 and $6 respectively, but now he is also willing to buy a 3rd cup, hence at P = $3, Qd is 3.
This forms a downward sloping individual demand curve. At lower prices consumers will buy more units, e.g. two rather than one at a time.
--𐤃 NON-PRICE DETERMINANTS--
--𐤃 NON-PRICE DETERMINANTS--
--𐤃 NON-PRICE DETERMINANTS OF DEMAND--
These factors result in changes in demand, even though the price has not changed. In other words these why are more/less of this good being demanded even though the price hasn't changed?
--𐤃INCOME--
When households have HIGHER INCOMES, assuming stable prices, their PURCHASING POWER increases (in other words their REAL INCOME RISES), which means they are more likely to DEMAND MORE and vice versa. Those goods which are demanded more are called 'NORMAL GOODS'.
--INCOME RISES => INCREASE IN DEMAND => 'NORMAL GOOD'--
--INCOME FALLS => DECREASE IN DEMAND => 'NORMAL GOOD'--
E.G LUXURY GOODS, TECHNOLOGY, TRAVEL, PRIVATE EDUCATION...
When households have HIGHER INCOMES, assuming stable prices, their PURCHASING POWER increases, which means they are more likely to DEMAND MORE and vice versa. Those goods which are demanded LESS of are called 'INFERIOR GOODS'.
INCOME RISES => DECREASE IN DEMAND => 'INFERIOR GOOD'
INCOME FALLS => INCREASE IN DEMAND => 'INFERIOR GOOD'
E.G NECESSITY GOODS, RICE, DOMESTIC FLIGHTS...
--TASK--
TIME TO THINK!
When INCOMES RISES, SPENDING ON MOST GOODS RISES ON AVERAGE, however, THE SIZE OF THIS INCREASE IN SPENDING (As a % of the increase in income) DIFFERS TREMENDOUSLY:
Q. If your income rose by ay 25%, say an extra $2000 pcm, would you expect your spending on FOODSTUFFS to increase by 25% (+$500)? Yes, no, why?
Q. If your income rose by ay 25%, say an extra $2000 pcm, would you expect your spending on SERVICES to increase by 25% (+$500)? Yes, no, why?
Q. If your income rose by ay 25%, say an extra $2000 pcm, would you expect your spending on MANUFACTURED GOODS to increase by 25% (+$500)? Yes, no, why?
--TASK--
TIME TO THINK...AGAIN!
Q. Do you think McDonald's is considered a NORMAL GOOD or an INFERIOR GOOD to the average SINGAPOREAN/ INDIAN/CHINESE?
What can we conclude about the importance of AVERAGE NAT'L/INT'L INCOME LEVELS, when we classify goods as normal or inferior?
What happens to overall demand for McDonalds if there is a large domestic wealth gap and average incomes increase? Will demand for McDonalds increase overall?
Are those that view it as a NORMAL GOOD greater than those who view it as an INFERIOR GOOD?
--𐤃PRICE OF SUBSTITUTES--
SUBSTITUTES are goods or services that are often bought as alternatives to other goods, therefore any CHANGE IN THE PRICE of one will have a direct impact on the DEMAND for the other.
For SUBSTITUTE Good X and Good Y:
If the PRICE of Good X RISES => The DEMAND for Good Y RISES.
If the PRICE of Good X FALLS => The DEMAND for Good Y FALLS.
--𐤃PRICE OF COMPLEMENTS--
COMPLEMENTS are goods and services that are usually bought in conjunction with the purchase of another good, therefore any CHANGE IN THE PRICE of one will have a direct impact on the DEMAND for the other.
For COMPLEMENTARY Good X and Good Y:
If the PRICE of Good X RISES => The DEMAND for Good Y FALLS.
If the PRICE of Good X FALLS => The DEMAND for Good Y RISES.
--EXPECTATIONS𐤃--
If the PRICE of Good X IS EXPECTED TO RISE => The DEMAND RISES.
If the PRICE of Good X IS EXPECTED TO FALL => The DEMAND FALLS.
--MOVEMENTS & SHIFTS--
--MOVEMENTS & SHIFTS--
--CETERIS PARIBUS--
--CAN THE LAW OF DEMAND BE VIOLATED?--
Given what you know about determinants of demand, can you explain how the following situations occur without violating the law of demand?
"The price of real estate is rising yet so is the demand"
"The price of I-phones are rising yet so is demand"
"The price of umbrellas are rising yet so is demand"
--CETERIS PARIBUS CONDITION--
In reality, both PRICE and NON-PRICE DETERMINANTS impact the amount of a good that is demanded by consumers, as such in order to study the relationship BETWEEN DEMAND and A SINGLE VARIABLE it is necessary to 'HOLD ALL OTHER VARIABLES CONSTANT' aka 'THE CETERIS PARIBUS CONDITION'
For example: When we state the LAW OF DEMAND we must write it like this: "As price rises the Qd falls, ceteris paribus".
--TASK--
https://courses.lumenlearning.com/introbusinesswmopen/chapter/simulation-demand-for-food-trucks/
Why does an increase in price not always lead to a decrease in the quantity demanded?
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