|This article needs additional citations for verification. (January 2009)|
In economics, demand is the utility for a good or service of an economic agent, relative to a budget constraint. (Note: This distinguishes "demand" from "quantity demanded", where demand is a listing or graphing of quantity demanded at each possible price. In contrast to demand, quantity demanded is the exact quantity demanded at a certain price. Changing the actual price will change the quantity demanded, but it will not change the demand, because demand is a listing of quantities that would be bought at various prices, not just the actual price.)
Demand is a buyer's willingness and ability to pay a price for a specific quantity of a good or service. Demand refers to how much (quantity) of a product or service is desired by buyers at various prices. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand. (see also supply and demand). The term demand signifies the ability or the willingness to buy a particular commodity at a given point of time.
- 1 Overview
- 2 Factors affecting elasticity of demand
- 3 Demand function and demand equation
- 4 Demand curve
- 5 Causes of the negative slope
- 6 Movements versus shifts
- 7 From individual to market demand curve
- 8 Price elasticity of demand (PED)
- 9 Market structure and the demand curve
- 10 Inverse demand function
- 11 Residual demand curve
- 12 Is the demand curve for PC firm really flat?
- 13 Demand management in economics
- 14 Different types of goods demand
- 15 See also
- 16 Notes
- 17 Further reading
Economists record demand on a demand schedule and plot it on a graph as a demand curve that is usually downward sloping. The downward slope reflects the negative or inverse relationship between price and quantity demanded: as price decreases, quantity demanded increases. Changing market price would move the equilibrium point for quantity demanded up and down ALONG the demand curve, but would not shift the demand curve - and would not change demand for the good. An actual change in demand means that the whole curve of quantity-demanded vs. price, has shifted. This curve is the demand, sometimes also called the demand curve. Change in demand and not just quantity-demanded could come from changes in consumer wealth, from consumer preferences, or from the prices of substitutes or complements for the product.
In principle, each consumer has a demand curve for any product that he or she is willing and able to buy, and the consumer's demand curve is equal to the marginal utility (benefit) curve, assuming full information and the lack of frictions that would perturb the consumer's choice. When the demand curves of all consumers are added up, the result is the market demand curve for that product which also indicates a negative or inverse relationship between the price and quantity demanded. If there are no externalities, the market demand curve is also equal to the social utility (benefit) curve.
Factors affecting elasticity of demand
Innumerable factors and circumstances could affect a buyer's willingness or ability to buy a good. Some of the more common factors are:
- Good's own price: The basic demand relationship is between potential prices of a good and the quantities that would be purchased at those prices. Generally the relationship is negative meaning that an increase in price will induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of the consumer demand curve. The assumption of a negative relationship is reasonable and intuitive. If the price of a new novel is high, a person might decide to borrow the book from the public library rather than buy it.
- Price of related goods: The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and gasoline.(Perfect complements behave as a single good.) If the price of the complement goes up the quantity demanded of the other good goes down. Mathematically, the variable representing the price of the complementary good would have a negative coefficient in the demand function. For example, Qd = a - P - Pg where Q is the quantity of automobiles demanded, P is the price of automobiles and Pg is the price of gasoline. The other main category of related goods are substitutes. Substitutes are goods that can be used in place of the primary good. The mathematical relationship between the price of the substitute and the demand for the good in question is positive. If the price of the substitute goes down the demand for the good in question goes down.
- Personal Disposable Income: In most cases, the more disposable income (income after tax and receipt of benefits) a person has the more likely that person is to buy.
- Tastes or preferences: The greater the desire to own a good the more likely one is to buy the good There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is assumed that tastes and preferences are relatively constant.
- Consumer expectations about future prices and income: If a consumer believes that the price of the good will be higher in the future, he/she is more likely to purchase the good now. If the consumer expects that his/her income will be higher in the future, the consumer may buy the good now.
- Population:If the population grows this means that demand will also increase.
- Nature of the good:If the good is a basic commodity, it will lead to a higher demand
- This list is not exhaustive. All facts and circumstances that a buyer finds relevant to his willingness or ability to buy goods can affect demand. For example, a person caught in an unexpected storm is more likely to buy an umbrella than if the weather were bright and sunny.
Demand function and demand equation
The demand equation is the mathematical expression of the relationship between the quantity of a good demanded and those factors that affect the willingness and ability of a consumer to buy the good. For example, Qd = f(P; Prg, Y) is a demand equation where Qd is the quantity of a good demanded, P is the price of the good, Prg is the price of a related good, and Y is income; the function on the right side of the equation is called the demand function. The semi-colon in the list of arguments in the demand function means that the variables to the right are being held constant as one plots the demand curve in (quantity, price) space. A simple example of a demand equation is Qd = 325 - P - 30Prg + 1.4Y. Here 325 is the repository of all relevant non-specified factors that affect demand for the product. P is the price of the good. The coefficient is negative in accordance with the law of demand. The related good may be either a complement or a substitute. If a complement, the coefficient of its price would be negative as in this example. If a substitute, the coefficient of its price would be positive. Income, Y, has a positive coefficient indicating that the good is a normal good. If the coefficient was negative the good in question would be an inferior good meaning that the demand for the good would fall as the consumer's income increased. Specifying values for the non price determinants, Prg = 4.00 and Y = 50, results in the demand equation Q = 325 - P - 30(4) +1.4(50) or Q = 275 - P. If income were to increase to 55 the new demand equation would be Q = 282 - P. Graphically this change in a non price determinant of demand would be reflected in an outward shift of the demand function caused by a change in the x intercept. Devon Clarke
Demand curve is a graphical representation showing different quantities of a good a consumer is willing to buy at different prices, assuming no change in other factors influencing demand, is called a demand curve of that consumer.
Causes of the negative slope
The negative slope of the demand curve is due to the diminishing marginal utility and the substitution and income effect. As the price falls, the number of units (product) where marginal utility (benefit) outweigh the marginal cost increases, thus it will continue to be a rational consumption for a larger number of units. The substitute effect is apparent because consumers will automatically switch to cheaper goods and move away from higher priced goods due to limited income and the desire to maximise their utility. When a good's price changes, a consumer's real income will be affected, in the case of a price decrease, they have greater purchasing power and their real income has increased. With this extra purchasing power, they are able to buy more and usually do (seen in normal goods).
Movements versus shifts
The demand curve is a two-dimensional depiction of the relationship between price and quantity demanded. Movements along the curve occur only if there is a change in quantity demanded caused by a change in the good's own price. A shift in the demand curve, referred to as a change in demand, occurs only if a non-price determinant of demand changes. For example, if the price of a complement were to increase, the demand curve would shift leftward reflecting a decrease in demand. Conversely, a rightward shift in the demand curve reflects an increase in demand. The shifted demand curve represents a new demand equation.
Movement along a demand curve due to a change in the good's price results in a change in the quantity demanded, not a change in demand. A change in demand refers to a shift in the position of the demand curve in two-dimensional space resulting from a change in one of the other arguments of the demand function.
From individual to market demand curve
The market demand curve is the horizontal summation of individual consumer demand curves. Aggregation introduces three additional non-price determinants of demand: (1) the number of consumers; (2) "the distribution of tastes among the consumers"; and (3) "the distribution of incomes among consumers of different taste." Thus if the population of consumers increases, ceteris paribus the market demand curve will shift outward (to the right). If the proportion of consumers with a strong preference for a good increases, ceteris paribus the demand for the good will increase. Finally if the distribution of income changes is favor of those consumers with a strong preference for the good in question the demand will shift out. Factors that affect individual demand can also affect market demand. However, net effects must be considered. For example, a good that is a complement for one person is not necessarily a complement for another; Further, the strength of the relationship would vary among persons. So in the aggregate the goods might be substitutes or complements. Finally the demand for a firm's product or services will often depend on such factors as competitors prices and marketing strategies.
Horizontal versus vertical summation
When adding individual demand curves it is critical that the summation be horizontal rather than vertical. The derivation of the market demand function involves adding quantities. The conventional graphical representation is of the inverse demand function. Adding inverse demand equations involves adding prices. In order to add the demand functions algebraically one must first convert the inverse equation to the standard demand function where quantity demanded is a function of price. For example, assume that there are two consumers in a given market and their respective demand functions are P = 30 - 2Q and P = 30 - 6Q. To sum these functions to obtain the market demand curve one must first convert to standard form, that is Q = 15 - (P/2) and Q = 5 - (P/6). Then, adding Q1 and Q2 yields 15 - (P/2) + 5 - (P/6) = 20 - (4P/6)= 20 - 2P/3.
Note that in aggregating individual demand curves to determine market demand one has to add the coefficients for the goods own price. The unexpressed assumption that is the basis for the addition is the law of one price. With some variables addition of coefficients is more problematic. For example income is an important determinant of demand. However, the percentage of additional income that a person would spend for a particular good or service varies widely making simple coefficient addition less tenable. To borrow an example from Nicholson assume that one has two consumers and that individuals 1’s demand for oranges is
X1 = 10 - 2Px + .1I1 + .5Py and individual 2’s demand for oranges is X2 = 17 - Px + 0.05I2 + .5Py
- Where Px = the price of oranges
- Py is the price of grapefruits
- I1 is consumer 1’s income
- I2 is consumer 2’s income.
The market demand functions would be X1 + X2 = 27 - 3Px + .1I1 + 0.05I2 + Py.
Specifying values for I1, I2 and Py and substituting them into the demand equation provided:
- X1 + X2 = 27 - 3Px + .1I1 + 0.05I2 + Py.
- X1 + X2 = 27 - 3Px + .1(40)1 + 0.05(20)2 + 4
- X1 + X2 = 27 - 3Px + 4 + 1 + 4
- X1 + X2 = 38 - 3Px
- If the price of grapefruits increased to 5 then the demand equation would become
*X1 + X2 = 39 - 3Px. Graphically this change in the price of a non price determinant of demand would be reflected in a shift out of the demand curve as the x intercept changed from 38 to 39.
- Note that if an income tax was imposed that transferred 5000 from individual 1 to individual 2 then the new demand equation becomes
'*X1 + X2 = 27 - 3Px + .1I1 + 0.05I2 + Py.
- X1 + X2 = 27 - 3Px + .1(35) + 0.05(25) + 5.
- X1 + X2 = 27 - 3Px + 3.5 + 1.25 + 5.
- X1 + X2 = 27 - 3Px + 9.75
- X1 + X2 = 36.75 - 3Px'
The redistribution of income has reduce demand and would be reflected in a shift inward of the demand curve. Note that the assumption that each person's demand for a good is independent of everyone else's demand for the same good is a necessary assumption for aggregation. Finally one must be aware that simple addition of coefficients can produce non-sensical results over certain range of prices. That is individual demand curves may not be valid at certain prices.
As Frank notes, "Horizontal summation works as a way of generating market demand curves from individual demand curves because all consumers in the market face the same market price for the product. But when incomes differ widely from one consumer to another, it makes no sense to hold income constant and add quantities across consumers."
Price elasticity of demand (PED)
PED is a measure of the sensitivity of the quantity variable, Q, to changes in the price variable, P. Elasticity answers the question of the percent by which the quantity demanded will change relative to (divided by) a given percentage change in the price. For infinitesimal changes the formula for calculating PED is the absolute value of (∂Q/∂P)×(P/Q).
Determinants of PED
The overriding factor in determining PED is the willingness and ability of consumers after a price changes to postpone immediate consumption decisions concerning the good and to search for substitutes (wait and look).
Elasticity along linear demand curve
The slope of a linear demand curve is constant. The elasticity of demand changes continuously as one moves down the demand curve because the ratio of price to quantity continuously falls. At the point the demand curve intersects the y-axis PED is infinitely elastic, because the variable Q appearing in the denominator of the elasticity formula is zero there. At the point the demand curve intersects the x-axis PED is zero, because the variable P appearing in the numerator of the elasticity formula is zero there. At one point on the demand curve PED is unitary elastic: PED equals one. Above the point of unitary elasticity is the elastic range of the demand curve (meaning that the elasticity is greater than one). Below is the inelastic range, in which the elasticity is less than one. The decline in elasticity as one moves down the curve is due to the falling P/Q ratio.
Constant price elasticity demand
where a and c are parameters, and the constant price elasticity is c and .
Market structure and the demand curve
In perfectly competitive markets the demand curve, the average revenue curve, and the marginal revenue curve all coincide and are horizontal at the market-given price. The demand curve is perfectly elastic and coincides with the average and marginal revenue curves. Economic actors are price-takers. Perfectly competitive firms have zero market power; that is, they have no ability to affect the terms and conditions of exchange. A perfectly competitive firm's decisions are limited to whether to produce and if so, how much. In less than perfectly competitive markets the demand curve is negatively sloped and there is a separate marginal revenue curve. A firm in a less than perfectly competitive market is a price-setter. The firm can decide how much to produce or what price to charge. In deciding one variable the firm is necessarily determining the other variable
Inverse demand function
In its standard form a linear demand equation is Q = a - bP. That is, quantity demanded is a function of price. The inverse demand equation, or price equation, treats price as a function g of quantity demanded: P = f(Q). To compute the inverse demand equation, simply solve for P from the demand equation. For example, if the demand equation is Q = 240 - 2P then the inverse demand equation would be P = 120 - .5Q, the right side of which is the inverse demand function.
The inverse demand function is useful in deriving the total and marginal revenue functions. Total revenue equals price, P, times quantity, Q, or TR = P×Q. Multiply the inverse demand function by Q to derive the total revenue function: TR = (120 - .5Q) × Q = 120Q - 0.5Q². The marginal revenue function is the first derivative of the total revenue function; here MR = 120 - Q. Note that the MR function has the same y-intercept as the inverse demand function in this linear example; the x-intercept of the MR function is one-half the value of that of the demand function, and the slope of the MR function is twice that of the inverse demand function. This relationship holds true for all linear demand equations. The importance of being able to quickly calculate MR is that the profit-maximizing condition for firms regardless of market structure is to produce where marginal revenue equals marginal cost (MC). To derive MC the first derivative of the total cost function is taken. For example assume cost, C, equals 420 + 60Q + Q2. Then MC = 60 + 2Q. Equating MR to MC and solving for Q gives Q = 20. So 20 is the profit maximizing quantity: to find the profit-maximizing price simply plug the value of Q into the inverse demand equation and solve for P.
Residual demand curve
The demand curve facing a particular firm is called the residual demand curve. The residual demand curve is the market demand that is not met by other firms in the industry at a given price. The residual demand curve is the market demand curve D(p), minus the supply of other organizations, So(p): Dr(p) = D(p) - So(p )
Is the demand curve for PC firm really flat?
Practically every introductory microeconomics text describes the demand curve facing a perfectly competitive firm as being flat or horizontal. A horizontal demand curve is perfectly elastic. If there are n identical firms in the market then the elasticity of demand PED facing any one firm is
- PEDmi = nPEDm - (n - 1) PES
where PEDm is the market elasticity of demand, PES is the elasticity of supply of each of the other firms, and (n -1) is the number of other firms. This formula suggests two things. The demand curve is not perfectly elastic and if there are a large number of firms in the industry the elasticity of demand for any individual firm will be extremely high and the demand curve facing the firm will be nearly flat.
For example assume that there are 80 firms in the industry and that the demand elasticity for industry is -1.0 and the price elasticity of supply is 3. Then
- PEDmi = nPEDm - (n - 1) PES,
- PEDmi = (-1) - (80 - 1) 3,
- PEDmi = -1(80) - (79 x 3)
- PEDmi = -80 - 237 = - 317
That is the firm PED is 317 times as elastic as the market PED. If a firm raised its price "by one tenth of one percent demand would drop by nearly one third." if the firm raised its price by three tenths of one percent the quantity demanded would drop by nearly 100%. Three tenths of one percent marks the effective range of pricing power the firm has because any attempt to raise prices by a higher percentage will effectively reduce quantity demanded to zero.
Demand management in economics
Demand management in economics is the art or science of controlling economic or aggregate demand to avoid a recession. Such management is inspired by Keynesian macroeconomics, and Keynesian economics is sometimes referred to as demand-side economics.
Different types of goods demand
Negative demand: If the market response to a product is negative, it shows that people are not aware of the features of the service and the benefits offered. Under such circumstances, the marketing unit of a service firm has to understand the psyche of the potential buyers and find out the prime reason for the rejection of the service. For example: if passengers refuse a bus conductor's call to board the bus. The service firm has to come up with an appropriate strategy to remove the misunderstandings of the potential buyers. A strategy needs to be designed to transform the negative demand into a positive demand.
No demand: If people are unaware, have insufficient information about a service or due to the consumer's indifference this type of a demand situation could occur. The marketing unit of the firm should focus on promotional campaigns and communicating reasons for potential customers to use the firm's services. Service differentiation is one of the popular strategies used to compete in a no demand situation in the market.
Latent demand: At any given time it is impossible to have a set of services that offer total satisfaction to all the needs and wants of society. In the market there exists a gap between desirables and the availables. There is always a search on for better and newer offers to fill the gap between desirability and availability. Latent demand is a phenomenon of any economy at any given time, it should be looked upon as a business opportunity by service firms and they should orient themselves to identify and exploit such opportunities at the right time. For example a passenger traveling in an ordinary bus dreams of traveling in a luxury bus. Therefore, latent demand is nothing but the gap between desirability and availability.
Seasonal demand:Some services do not have an all year round demand, they might be required only at a certain period of time. Seasons all over the world are very diverse. Seasonal demands create many problems to service organizations, such as:- idling the capacity, fixed cost and excess expenditure on marketing and promotions. Strategies used by firms to overcome this hurdle are like - to nurture the service consumption habit of customers so as to make the demand unseasonal, or other than that firms recognize markets elsewhere in the world during the off-season period. Hence, this presents and opportunity to target different markets with the appropriate season in different parts of the world. For example the need for Christmas cards comes around once a year. Or the, seasonal fruits in a country.
Demand patterns need to be studied in different segments of the market. Service organizations need to constantly study changing demands related to there service offerings over various time periods. They have to develop a system to chart these demand fluctuations, which helps them in predicting the demand cycles. Demands do fluctuate randomly, therefore, they should be followed on a daily, weekly or a monthly basis.
- Demand chain
- Demand curve
- Demand schedule
- Derived demand
- Planned obsolescence
- Law of demand
- Law of supply
- Supply (economics)
- Supply-side economics
- Supply and demand
- Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 79. ISBN 0-13-063085-3.
- Besanko and Braeutigam (2005) p. 146-47.
- Rittenberg and Tregarthen. Principles of Microeconomics: Chapter 4. Retrieved June 19, 2012
- Nicholson & Snyder, Intermediate Microeconomics (Thomson 2007) p. 114–115.
- A firm will not know the individual demand functions. So a firm could not derive its market demand curve by aggregating individual demand curves. There are empirical studies that estimate demand. As a rule of thumb the firm's demand curve is 5 to 6 times more elastic than the market demand curve. Thus a manager could take the market coefficient and multiply it by 6 to obtain the firm's PED. d
- Binger & Hoffman, Microeconomics with Calculus, 2nd ed. (Addison-Wesley 1998) at 154-55
- Binger & Hoffman, Microeconomics with Calculus, 2nd ed. (Addison-Wesley 1998) at 154-55.
- Nicholson & Snyder, Intermediate Microeconomics (Thomson 2007) at 116.
- Hirschey, Mark Managerial Economics Rev. Ed. (2000) 80-81.
- Besanko and Braeutigam (2005) p 169.
- Besanko p. 169.
- Frank, R., Microeconomics and Behavior 7th ed. (Mc-Graw-Hill) ISBN 978-0-07-126349-8.
- Nicholson (1998)186-89.
- A more difficult problem with integration occurs when the system exhibits feedback. For example, consumer 1's taste and preferences may influence consumer 2's which in turn affect consumer 1's tastes and preferences.
- Besanko and Braeutigam (2005) p. 169.
- Frank p. 121.
- Colander, David C. Microeconomics 7th ed. pp. 132-33 McGraw-Hill 2008.
- Colander, David C. Microeconomics 7th ed. pp. 132-33. McGraw-Hill 2008.
- The perfectly competitive firm's demand curve is not in fact flat. However, if there are numerous firms in the industry the demand curve of an individual firm is likely to be extremely elastic, for a discussion of residual demand curves see Perloff (2008) at pp. 245–246.
- The form of the inverse linear demand equation is P = a/b - 1/bQ.
- Samuelson, W & Marks, S. Managerial Economics 4th ed. p. 37. Wiley 2003.
- Perloff (2008) p. 243.
- Perloff (2008) p. 245–246
- Perloff (2008) p. 244.
- Prloff (2008) p. 243.
- Ehrbar, Al (2008). "Supply". In David R. Henderson. Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267.
- Henderson, David R. (2008). "Demand". Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 978-0865976658. OCLC 237794267.
- Friedman, Milton (December 1949). "The Marshallian Demand Curve". Journal of Political Economy 57 (6): 463. doi:10.1086/256879. JSTOR 1826553.