Demand

An individual's demand refers to their willingness and ability to purchase goods and services at particular prices, and thereby satisfy their want's and needs. 'Market' demand refers to the sum of all individual demand at various prices.

The determinants of demand

Consumer demand is influenced by price, and a range of non-price factors.

Demand and price

The economist models demand by, firstly, holding all possible factors constant, and then varying the factor - or determinant - under consideration. The starting point for the model of demand (and supply) is the price of a good or service. The quantity demanded at various prices can be mapped using a demand schedule.

Price and quantity demanded are usually inversely related - at lower prices consumers will consume more.

Example

The following market demand schedule shows how the quantity demanded for bottled water varies over a range of hypothetical prices (expressed in $'s). A demand curve is derived from the schedule.

Demand schedule and demand curve

Given that the relationship between quantity demanded and price is inverse, a demand curve is, typically, downward sloping. There are several explanations of the downward slope of a demand curve:

Diminishing marginal utility

The principle of diminishing marginal utility suggests that marginal utility, or benefit, declines as more of a good is consumed - this means that a lower price is necessary to 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 consumed, given that most utility is derived from the earliest units consumed. In the case of bottled water, thirst will be substantially satisfied by drinking the first bottle - in our example, a consumer is prepared to pay $3.00 for the first bottle consumed, and only $.2.50 for the second.

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 [the 'equi-marginal' principle of consumer equilibrium].

Consumer equilibrium

Marginal utility

Hence, if a consumer spends all their income on just three goods, Apples (A), Bananas (B) and Carrots (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 to re-establish the 10/1 ratio. This can only be achieved by 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

Non-price determinants of demand

Demand for specific goods and services is also determined by several 'non-price' determinants. Whenever a non-price determinant changes the demand curve which shift its position.

Shifts in demand curves

What factors shift demand curves?

Shifts in demand
Price elasticity

How responsive are consumers to price changes?

Price elasticity
Supply

Why does a supply curve slope upwards?

Supply curves
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