Demand

Demand refers to the consumer's willingness and ability to purchase goods and services. Demand can be mapped against price through a demand schedule, which can then be used o derive a demand curve.

A demand curve, typically, slopes down from left to right. Price and quantity demanded are usually inversely related - at lower prices consumers will consume more.

Example

We can derive a demand curve from a demand schedule.

Demand schedule
Demand curve

Given the negative relationship between price and the quantity demanded, a typical demand curve will slope downwards. There are several explanations of the downward slope of a demand curve:

Diminishing marginal utility

Marginal utility, or benefit, falls as more is consumed - and only a lower price will encourage demand. ‘Marginal’ is an important concept in economics and means the ‘additional’ amount of something resulting from an economic action – in this case, marginal utility is the additional benefit gained from consuming one more unit of a good or service.

In the example, the consumer is happy to pay a relatively high price for fewer units, given that most utility is derived from the earliest units consumed.

At higher quantities the consumer expects the marginal benefit of extra units to be less than before, and will therefore expect the price to be lower for these additional units.In simple terms, the consumer will expect the ratio of marginal utility and price to be the same for all goods consumed, so if a good rises in price marginal utility will be adjusted by consuming less.

Consumer equilibrium

Marginal utility

So, for example, is a consumer spends all their income on three goods, A, B and C they will be 'in equilibrium' when the ratio of marginal utility (MU) to price (P) will be equal - as we can see, the ratio is MU10/P1.

If the price of good B (Bananas) rises from its current level of 20 to 40, then the individual is pushed into a disequilibrium state. The obvious way to address this it is to 'increase' the level of MU to 400. This can only be achieved buy consuming less (given the underlying principle of diminishing marginal utility.)

Demand curve
Demand for bananas
Video on demand and supply curves, and economic welfare

Demand can also be explained in two other ways.

Income and substitution effect

If budgets are fixed, a lower price means more can be consumed - providing more ‘real’ income. For example, if a consumer has a budget of $2400, then at a price of $6 (at point A) he or she can buy 400 units of good X. If the price falls to $2, then the consumer can purchase 1200 units.

In a similar way, if prices of substitutes to good X are constant, a lower price of good X will encourage consumers to switch to good X.

In most cases, the income and substitution effect combine to create the negative price/demand relationship.

The two effects are called the ‘income effect’ and ‘substitution’ effect.

Income and substitution effect

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