3:Demand }} 39 + The amount that people earn, their wealth, and the relative prices of products determine who can afford to buy different goods and services. In these markets individual consumers, businesses and employees are making their own decisions based on a desire to maximize their well-being. The price and wages adjust to bring these decisions together. As supply and demand conditions change the prices adjust to bring about a new equilibrium with a different allocation of resources. Imagine that changes in technology lead to a greater demand for website designers and less demand for travel agents, because people can search for and book holidays directly online. This should lead to more web design companies setting up and more designers being recruited. Demand for this service, and therefore demand for resources in this in- dustry, increase, highlighting how the markets for products and factors of production are linked. Meanwhile, there will be less demand for travel agency services and these busi- nesses may have to make people redundant. Less demand for the product reduces demand for resources in this industry. The combination of products produced by the economy has moved, so that we are at a new point on the production possibility frontier (PPF). In the market for the different factors of production, rewards will go up for the web designers and down for the travel assistants, bringing about the reallocation of resources as the economy adjusts to change. An economy is made up of millions of markets, and an understanding of supply and demand conditions is therefore crucial to economic analysis, All markets, whether for housing, oil, shares, labour, property, currencies, or even university places, are influenced by the market forces of supply and demand. We shall therefore begin with an analysis of demand in this chapter, then look at supply in Chapter 5, and finally put the two sides of a market together to examine the concept of equilibrium in Chapter 6, & The demand curve ‘The demand for a product is the quantity that customers are willing and able to buy at each and every price, all other things being unchanged. This is shown on a demand curve. Addemand curve measures the quantity that customers are actually able to buy at each and very price, not only the quantity that they would like to buy. It therefore represents what iscalled ‘effective demand’, and depends on what they want and what they can afford. For example, at the price P1, the quantity QI is demanded (see Figure 3.1). Ata lower price, 2,2 greater quantity Q2 is demanded. With a given income customers are able to and “want to buy more with a lower price. The level of demand for a product depends on factors such as the following. The price level As the price changes, this influences the relative value of the product compared with other goods and services, and the amount that customers want and are able to buy. Higher tuition fees may deter some students from going to university, for ~ example. Lower prices may make a product more affordable and increase the quantity demanded. Given your existing income and preferences, changes in price affect what is affordable and how much you demand.Demand iEP= " = By the end of this chapter, you should be able to: — > ey oe explain what is meant by effective demand; ree ts . cet a explain what is shown by a demand curve; ee understand the difference between a change in the quantity t demanded and a change in demand; explain the possible causes of a shift ina demand curve; appreciate the difference between marginal and total utility Ina free market economy, the basic economic problems of what to produce, how to pro- duce, and who gets what are solved by market forces. ‘The demand and supply of goods and services determine what is produced and sold, The demand and supply of resources determine the combination of different resources being used—for example, how much labour and how much machinery are employed in a given industry, and how much people are paid. |40 )) Foundations of Economics Price (£2) Demand curve =D Quantity (units) ai 02 Figure 3.1 Price changes are shown by a movement along a demand curve. SSE Put into practice Price (£) Pa ° ° Quantity 08 a4 tunits) Figure 3.2 Price and quantity combinations. Consider the demand curve in Figure 3.2. ‘= What quantity is demanded at price P3? ‘+ What price is necessary for quantity 04 to be demanded? * The customers’ incomes This influences what customers can afford. If the economy is booming, for example, and people are earning more, this might lead to more spending on many goods, + The price of competitors’ products (that is, substitute products) A change in the price of Cadbury's Dairy Milk, for example, may affect the sale of Mars bars. A decrease3:Demand }} 41 in the price of satellite navigation devices may reduce demand for maps as customers switch from one product to another. * The price of complementary products (that is, products used in conjunction with each other) For example, an increase in the price of Sony Playstation consoles may affect sales of Playstation computer games. If you cannot afford one part of the overall package, demand for specific elements may fall. If you cannot afford the computer printer you won't buy the ink. + The number of customers in the market For example, a produet may be aimed at a new market segment (such as a new country or a new group of buyers}, which can boost demand. When several sports clothes manufacturers repositioned many of their products and targeted the leisurewear marker, this significantly increased the number of potential buyers for their products. Computer games are now being developed to help to improve the memory and to keep users alerts this isto target the older buyer, because most buyers of computer games at the moment are relatively young, Cereal manufac- turers are regularly trying to reposition the product to get customers to view this as a product to eat in the evening as well as the morning, + Other factors ‘The factors affecting the demand for a particular product will, of course, vary. For example, the demand for textbooks will be influenced by the number of stu- dents; the demand for sun-cream will be influenced by the weather; the demand for nico- tine patches may be affected by anti-smoking laws. In 2013 the bicth of Prince George to the Duke and Duchess of Cambridge is estimated to have boosted retails sales by over £240 million thanks to spending on celebrations, souvenirs, toys, books, and DVDs. © The shape of the demand curve A demand curve is usually downward-sloping. This is because of the law of diminishing marginal utility, This law states that, as buyers consume additional units of a product, the extra satisfaction (or utility) that they gain from each unit will fall. The second cup of tea is not as satisfying as the first in a given time periods the tenth is not as satisfying as the ninth. If the extra satisfaction of a unit declines, then the amount that consumers are willing to pay to buy it will fall as well. For a higher quantity to be demanded, the price must therefore be lower, because the extra satisfaction from these additional units is less according to the law of diminishing marginal utility. We are assuming that consumers are rational and that, given a limited income, they allocate their spending between products tomaximize their welfare. If by consuming more of a particular product the extra satisfac- tion falls, then you will only be willing to buy more units if they become cheaper. a Marginal and total utility * Marginal utility measures the extra utility (or satisfaction) from consuming an additional unit of a product. + Total utility is the total satisfaction from the consumption of a product.42 )) Foundations of Economics Table 3.1. The relationship between marginal utlty and total utility 1 0 10 2 8 8 3 6 24 4 4 28 5 2 30 6 0 30 a 2 28 8 at 24 If, for example, the extra utility from consuming another unit of the product is six units of utility (called ‘utils), then the total utility will increase by 6 utils. Notice in Table 3.1 that the law of diminishing marginal utility operates (see also Figure 3.3). This means that the total utility increases at a diminishing rate. When the marginal utility is 0, this means that there is no increase in total satisfaction from the consumption of that unit (in this case, the sixth unit); at this level of consumption, utility would be maximized. Ir is possible that you can overconsume some items (for example, eat or drink too much in a given time period and feel ill), in which case the marginal utility might be negative (the seventh unit) and the total utility would then fall. @ 1 ‘Marginal Total wtity vtlity (ots) (otis) 0 30 8 2 “ 24 8 4 . 0 ° ° [ Quantity 12 9 4 5 6 7 Quanty 2 units) (units) Figure 3.3 The relationship between (al marginal utility and (b) total utility.3:Demand >) 43 The difference between marginal and total utility is highlighted by the ‘paradox of value’, In the case of water, there is a relatively large amount of water available and consumed in the world. This means that, although total utility is high, the extra utility is low and therefore people will not pay much for an additional unit of this, even though it is essential to survival. In the case of diamonds, the availability and consumption is much lower, meaning the marginal utility is high (although roral utility is not, compared with water); peoply will pay a lor for another diamond even though it is not essential to survival. Put into practice What is the maximum number of units the consumer will consume if the price of the product is. 4 ppence (assuming | unit of utlty is worth 1 pencel? © Amovement along the demand curve The rational consumer will consume any unit shown on the demand curve where the extra utility is greater or equal to the price charged. This means that if the price of a product falls, then there will now be more units that have a higher extra utility than the price, and the quantity demanded will increase. If the price increases, there will be fewer units worth purchasing and the quantity demanded will fall. A change in the price of a product, such as P1 — P3 (see Figure 3.4), therefore leads to a change in the quantity demanded (Q1 ~ Q3). This is known as a movement along the demand curve. ‘An increase in the quantity demanded due to a price fall is called an extension of de- mand (Q1 ~ Q3).A decrease in the quantity demanded is called a contraction of demand (Qi-Q).44 )) Foundations of Economics Price (€) P3 Quantity (units) Figure 3.4 A movement along a demand curve (caused by a price changel and a shiftin demand. Example The equation fora straight-line demand curve can be given in the form: Q=a-bP For exomple: =80-2P where * Gis the quantity demanded: and * Pisthe price in £s, ©, the price is £5, the quantity demanded is: Q=80-(2x5}=80-10=70 units Ifthe price increases to £10, the quantity demanded is: = 80—[2x10)= 80-20 = 60 units This shows that, glven this equation, the higher the price, the lower the quantity demanded. This is shown as a rmavement along the demand curve, because the price hhas changed. 1». ithe equation changes to Q = 150 - 2P, then the curve will have shified, because more will be demanded at each ond every price. So, ifthe price is £5, the quantity demanded is: 150-{2%5}= 150 10= 140 unitsIfthe price increases to £10, the quantity demanded is Q= 150-1210) = 150-20 = 130 units © = 80-2? ond the quantiy demanded is 50 units, then: 50=80-2P ‘also expressed as 2p =80-50 2 =30 30. ns This quantity is dernanded at a price of £15, Put into practice ifthe equation for a demand curve is Q = 50 ~4P. ‘whats the quantity demanded ifthe price is £5? * whats the quantity demanded ifthe price is £10? * whats the price at which the quantity demanded is 46 units? ‘* what isthe price at which the quantity dernanded is 42 units? Income and substitution effects Movements along the demand curve can also be explained in terms of income and sub- stitution effects * The substitution effect occurs when consumers switch towards a relatively cheaper product. If the prive of a product falls, we assume that consumers always switch to- wards it, because it is relatively cheaper than alternatives, and so the substitution effect increases the quantity demanded. * The income effect occurs because, if a good is cheaper, consumers can purchase more products with the same nominal income. Their money can buy more, which means that their real income has increased. In the case of most goods, having more real income increases the quantity demanded. This means that, with a fall in price, consumers substitute towards the relatively cheaper product; with more real income, they want to purchase more. These two effects increase the overall quantity demanded (see Figure 3.5).46 )) Foundations of economics Substitution ngs q Ae Overall increase in ‘quantity demanded Figure 3.5 The income and substitution effects following a price fall ™@ Upward-sloping demand curves In exceptional cases,the demand curve fora product may be upward-sloping (see Figure 3.6). This may be due to one of the following two reasons. + The product is a Giffen good This is a very basic product that is essential to survival in.a poor economy, such as tice in a developing country. When the price of this type of product rises, consumers find that they are spending so much on it (because i is essen- tial to survival and one of the few things that they can afford to eat) that they have very little left over for anything else. Given the fact that consumers have so few funds left, they end up buying even more of the original produet—that is, the quantity demanded increases when the price increases, because nothing else is now affordable. © The product is a Veblen good Customers believe that the higher price of the product reflects a better quality or has a better image, and therefore want more even though itis more expensive. This type of product was described by Veblen (1899) who highlighted the desire by some customers for ‘conspicuous consumption’—that is, they want to be seen to be buying more expensive items! For example, retailers sometimes find that a Price (£) 1 i i | : | ! I | ! a ‘Quantity les mee (units) Figure 3.6 An upward-sloping demand curve.3: Demand Peed tees os ay eek In 2007 two Harvard professors, Robert Jensen and Nolan Miller, analysed the behaviour of oor Chinese consumers and showed that they consume mare rice or noodles, their staple food products, as the prices of these products go up. They showed that people need a certain ‘amount of calories to survive—for example, 1600 per day. They could get this by consuming rice. ‘ond perhaps some vegetables alone, or by eating rice, vegetables, and a few pieces of meat. But meatis expensive andas the price of rice increased the poor Chinese could no longer afford the luxury of cooking meat, so they ate rice instead, which was stil relatively cheap compared tomeat. @ Question Do you think Gifen goods might exist in the UK? What might they be’ reduction in the price of a bottle of wine leads to a fall in sales, because buyers assume that the quality is worse or do not want to be seen buying cheap wine (or giving it to their guests). _ What do you think? id ask ono inked tet you buy fe whi ye end ved he cheapest vrstanon he | Sstiny doyoutinkyou doo? aarti RB, 2 Put into practice tthe equation for a demand curve is Q= 20+ 2P, why does this mean that the demand curve for ‘his product is upward-sloping? Show your answer, using calculations to calculate the quantity ‘demanded for different prices. Interms of income and substitution effects, what is happening with Giffen goods is that fallin price means that: ‘consumers want to substitute towards this product, so this substitution effect eases the quantity demanded; and ‘an increase in real income due to the lower price leads to a fall in quantity demanded ‘consumers switch to more luxurious goods. This is the income effect reducing the tity demanded. case of a Giffen good the substitution and income effects therefore work against ‘other, and the income effect outweighs the substitution effect. This means the > 47Foundations of Economics Substitution Gee 1 i ‘ | i T t Income ies effect = /— Overal effect on quantiy demanded citer a pice fal ° t ‘ t i I i i i | 1 Quantity See (units) Figure 3.7 Income and substitution effects on a Giffen good. overall quantity demanded falls with a price fall (see Figure 3.7) and the demand curve is upward-sloping, A shift in the demand curve A movement along a demand curve occurs when the price changes and all other things remain unchanged, A shift in demand occurs if these other factors do change. The de- mand curve for a product will shift if at each and every price customers are willing and able to buy more or less than they did before (see Figure 3.8). If consumers demand more, the curve will shift to the right. If they demand less, then it will shift to the left. When the demand curve shifts, this is known as a change in demand (as opposed to a change in the quantity demanded). ‘What do you think? What do you think will be the big hit in the toy market next Christmas? How would you try to estimate this?3:Demand >> 49 } ib) Price (2) Price (2) Pl Pl Pa gure D ° Quantity ob quantity (units) (units) Figure 3.8 {o) An increase in demand; tb) A decrease in demand. ™@ The reasons for a shift in demand ‘The reasons for a shift in demand (that is, a change in demand) include the following. * A change in income If customers have an increase in their incomes, then their demand for products is likely to shift. For ‘normal? goods, demand will increase with more in- come and the demand curve will shift to the right. With more money, you may go on holiday more, eat out more, and go to more concerts. More is demanded at each and evety price. The amount by which the demand for a particular product increases de- pends on how sensitive it is to changes in income, A given increase in income may lead toa relatively large inerease in demand for health clubs and fine wines, for example. ‘These goods are known as income elastic products. For other goods, demand may not increase so much, An increase in income is unlikely to boost demand for shoe polish or toothpaste very much, for example. These are known as income inelastic products. (For more on income elasticity, see Chapter 4.) For some goods, demand may actually fall when income increases, because the con- sumers switch to something that they prefer now that they have more income. Goods for which demand falls in this way are called inferior goods. When households’ income in developing economies grow, they usually switch from bicycles to motorbikes as a ‘means of transport. The bicycles in this case are inferior and the motorbikes are normal products, However, the status of goods will vary for different people and over time. With even more income growth in developing economies, demand for motorbikes tends tofall as demand for cars increases. Motorbikes have now become inferior over time, as consumers now choose another, better’, product. A change in marketing policies Managers of organizations will continually review their marketing strategies to try to boost the demand for their products. Changes to ‘their marketing strategy may include new promotional campaigns or finding new50 )) Foundations of Economics ‘What do you think? Imagine that you win £1 milion on the lottery, What products would you buy more of? What would you buy less of? distribution channels to make it easier for customers to buy the products. Effective marketing should shift the demand curve to the right. + A change in the number of buyers Over time, more people may move into an area or a country, cteating more potential buyers. Alternatively, a change in customers’ tastes may lead to more demand. In recent years, for example, there has been an increasing in- terest in healthy foods and fitness. This has increased demand for low-fat products and health clubs. At the same time, it has shifted demand for many fast-food restaurants to the left. Companies such as McDonald’s have had to reconsider their range of products and marketing strategies. + A change in the price of substitute products Customers have choices when it comes to deciding what to buy. You may be deciding whether to go for a meal out or the cinema, or choosing between decorating the kitchen and going on holiday. This means that all products have substitutes—that is, other products that customers may consider buying asanalternative. If these substitutes become more or less expensive, then this will affect demand for the original product. For example, if the price of football tickets goes up, you may decide to stop going to see the match every week and spend your money on ‘Sky TV instead. The demand for Sky TV would shift to the right, because the price of football tickets increased. Easy, cheap access to reviews of restaurants, hotels, and cities online i leading to a fall in demand for guide books. A change in the price of complements Complementary products are those that you tend to buy together, for example, writing paper and envelopes, digital cameras and photographic printing paper, and flowers and greeting cards. Changes in the price of one of these items may affect sales of the other. If the cost of filter coffee increases sig- nificantly, it may decrease sales of filter coffee machines. Ifthe price of airfares to Spain falls, the sales of suneream may increase as more people go abroad. © Weather Changes in the climate can havea significant effect on the sales of some products. A hot summer boosts the demand for barbecues and lager. Amazingly, it also boosts sales of tanning lotion: office workers want to give the impression that they have been outside or on holiday and so buy fake tan. A wet winter increases the demand for umbrellas. ‘© Events Big events, such as sporting matches, can have a large impact on retail sales. In the build“up to an event such as the Olympics, retail sales are high as people stock up; sales are low during the competition, because people stay at home to watch it. © A change in social patterns Over time, the nature of society will change and this influ- ences demand patterns for different products. In the UK, for example, the average age has been increasing over the last $0 years, the typical family size has been decreasing,3: Demand ‘The owner of 88, Kingfisher, announced a fall in profits last year due to weak demand caused by cold weather. Kingfisher is Europe's largest DIV retailer. As well as the impact of cold weather, the company was also affected by weak consumer confidence in its main markets. Sales of outdoor products were hit at B&Q and the company said that sales of building products were aiso oe the poor weather. This affected the share price of the company. @ wostions Expiain the possible effect on B&Q ofthe fal in profits. “Analyse two factors that might affect demand for B&Q products \What other products maybe vinerable to changes in the weather? \What could B&Q do to reduce its winerabiltyo changes in the weather? there are more divorces, and there is a greater interest in healthy and organic foods. A noticeable development in the UK has been a change in the way in which we eat. Families are much less likely to sit down together and eat a family meal than they were 20 years ago; Sunday dinners are largely a thing of the past and we tend to eat now by ‘grazing’—that is, by eating as we move about. This has helped firms such as Pret A Manges, which sells sandwiches, but negatively affected others such as Waterford and Wedgwood, which make traditional bone china crockery—something for which there is much less need these days, because formal meals are increasingly uncommon, What do you think? What do you think are the major determinants of the demand for each of the following? co. Newcars Textbooks: «Diamonds d. Health care e. Flat-screen TVs 1 Eggs fo practice Using diagrams, show the effect on demand of the following, * The effect on demand for « normal good if income decreases Pu * The effect on demand for an inferior good if income increases52. )) Foundations of Economics * The effect on demand for a product of an increase in the price of a complementary product * The effect on demand for a product of a decrease in the price of a substitute product 2. What is the only cause of a movement along a demand curve for good x? ‘9. Achange in consumers‘ tastes b. Achangein consumers’ income ‘} 53 Price ie) . aca anamas Quantity Quanity uanity (onts) (unis) ‘uns Inca rectal Maat ‘semana lamand derane Figure 3.9 The market demand. Table 3.2 Summary Change in Leadsto Price MOVEMENT ALONG THE DEMAND CURVE hacome Pres of other products Prometional octvies A SHIFTIN THE DEMAND CURVE Tastes it Number of customer 12018 Micrasof announced the launch date and price forts new Xbox One. It nnounced that thenewcon- would goon sale in November in thal year, with a recommended reall price of £429 in the UK, $499 in 1USA, and 499 euros. Rival console manufacturer Sony said ts console would be also be out later in 2013. This was the fis ime the two rivals had launched their produces simultaneously. Previously consoles {been released at leas! a year oport Microsoft has announced tiles such as Forza Motorsport which cloud! gaming and others—such as Konami's Metal Gear Solid 5—which may include real-time 8. Even Ifyou are not playing, things will be happening and stories will move on. A good games ramatically increase the popularity and sales of a new console, Many commentators claim the of Microsoffs firs! console—the Xbox—when if launched in 2001—was due to it securing the rights to the first person shooter game Halo, people feel the high price ofthe new Xbox in the UK isan issue but others say he Xbox 360 has. Unique Features it will not cause the company any problems. it may be thatthe inital price is down fairly quickly.54 )) Foundations of Economics When Microsoft launched the Xbox 360 in 2005, it had o launch price in the UK of £279.99, $399 in the USA and 399 euros. @ Questions 1 What factors do you think will influence demand for the new Xbox? 2. Howensitve to price do you think demand for he Xbox is likely 0 be? 3. Analyse the possible reasons why the price of the Xbox differs in different countries, 4 Analyse the possiblé reasons why the price ofthe Xbox might fall over time, Does a demand curve show what a consumer would like fo buy at each and every price? Explain the difference between a movement along, and a shittin, a demand curve. ‘Does an increase in income always shif the demand curve outwards to the right? Explain your answer. Does the quantiy demanded ohways fal if the price increases? ‘Jo what extent do you think « business can control the demand for its products? Explain what might shif the dernand curve fora product inwards. marginal ulityis fling does this mean total uly is folling as well? 4 5 6 7 8 Explain what happens to the demand for a product ifthe price of a complement rises. 1 Ifthe equation for the demand curve is G = 300 ~ 2P what is the quantity demanded when the price is £10? £20? 2 Themarginal utility for each additional unit of consumption is 12 units of ulity then 10, 7, 5, 2, 2,4, Plot the total utlty derived from the consumptions of these units. 1 Visit the website of the Advertising Standards Authority. Summarise the role of the authority ‘and analyse the findings in a recent investigation it has undertaken, 2 Anincrease in the quantity demanded is not the same as an increase in the demand for a product. Explain the difference using diagrams3:Demond )) 55 © Demand shows what customers are willing and able to purchase at each and every price, not only what they want fo buy. * A movement along o demand curve occurs when there is a change in the price, all other things being unchanged '* A shift in the demand curve occurs when more or less is demanded at each and every price. ® A demand curve is usually downward-sloping, but in some cases (such as a Veblen or Giffen good), it can be upward-sloping. ‘©The marginal utily shows the exira ullity rom consuming a unit; the total utlity shows the ‘otal satisfaction thot a consumer has from consuming a product. © The marginal utility from consuming @ product declines when additional units are consumed. ‘Ademand curve can be derived using indifference curve analysis. This analyses the impact of ‘achange in price and income In terms of consumers’ utlity. To find out more about indifference curve analysis and how a consumer maximizes tlty, visit the Online Resource Centre. Visit our Online Resource Centre at hitp://www.oxfordtextbooks.co.uk/orc/gillespie_ ‘econ3e/ for test questions and further information on topics covered in this chapter.