Demand curve

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An example of a demand curve

In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule.[1] The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together.

Demand curves are used to estimate behaviors in competitive markets, and are often combined with supply curves to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are willing to buy, also known as market clearing price) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market.[2]

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[edit] Characteristics

According to convention, the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. The function actually plotted is the inverse demand function.

The demand curve usually slopes downwards from left to right; that is, it has a negative association (for two theoretical exceptions, see Veblen good and Giffen good). The negative slope is often referred to as the "law of demand", which means people will buy more of a service, product, or resource as its price falls. The demand curve is related to the marginal utility curve, since the price one is willing to pay depends on the utility. However, the demand directly depends on the income of an individual while the utility does not. Thus it may change indirectly due to change in demand for other commodities.

[edit] Demand schedule

A demand schedule is a table that lists the quantity of a good a person will buy at each different price[1] The demand curve is a graphical depiction of the relationship between the price of a good and the quantity of the good that a consumer would demand under certain time, place and circumstances. The demand relationship can also be expressed mathematically - Q = f(P⎮Y, Prg, Pop, X) where Q is demand, P is the price of the good, Prg is the price of related goods, Y is income, Pop is population and X is expectations. The vertical bar means that the variables to the right are being held constant together with all other circumstances that could affect the consumer's demand decision. An example of a full demand equation is Q = 225 - P + 20Ps - 30Pc + 0.90 Pop + 1.5Y. If you specify the values of variables Ps equals 3.00, Pc equals 2.50, Pop equals 12.5 thousand and y equals 18.5, then the equation becomes:

  • 225 - P + 20(3) - 30(2.5) + 0.90(12.5) + 1.5(18.5).
  • 225 - P + 60 - 75 + 11.25 + 27.75
  • 225 - P + 99
  • 324 - P

This exercise illustrates that the variables other than the goods own price are being held constant and are part of the constant term. If one of these other variables changes the intercept will change causing the curve to shift. For example, if population increased to 15 thousand then the constant term would increase by 1 and the new equation would be 325 - P. This change in the equation would be expressed as a shift out of the demand curve. The movement is described as a change in demand. Movements along the demand curve occur only when quantity demanded changes in response to a change in price.

[edit] Shift of a demand curve

The shift of a demand curve takes place when there is a change in any non-price determinant of demand, resulting in a new demand curve.[3] A non-price determinant of demand are those things that will cause demand to change even if prices remain the same. In other words, what things might cause a consumer to buy more or less of a good even if the goods own price remained unchanged.[4] Some of the more important factors are the prices of related goods (both substitute and complementary), income, population and expectations. However, demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances; so, any relevant circumstance can be a non price determinant of demand. As an example, weather could be factor in the demand for beer at a baseball game.

The shifted demand curve is a new demand equation. For example assume demand is Q = 225 - P + 20Ps - 30Pc + 0.90 Pop + 1.5Y and assume that demand shift 30% to the left. The new demand equation will be Q = .70(225 - P + 20Ps - 30Pc + 0.90 Pop + 1.5Y) = 157.5 = .7P + 14Ps - 21Pc + 0.63Pop + 1.05Y.

When income rises, the demand curve for normal goods shifts out as more will be demanded at all price levels, while the demand curve for inferior goods shifts in due to the increased attainability of superior substitutes. With respect to related goods, when the price of a good (e.g. a hamburger) rises, the demand curve for substitute goods (e.g. chicken) shifts out, while the demand curve for complementary goods (e.g. tomato sauce) shifts in (i.e. there is more demand for substitute goods as they become more attractive in terms of value for money, while demand for complementary goods contracts in response to the contraction of demand with the underlying good).[3]

[edit] Causes of shifts in demand

  • Changes in disposable income
  • Changes in taste and fashion (changes in preferences) - tastes and preferences are assumed to be fixed in the short-run. This assumption of fixed preferences is a necessary condition for aggregation of individual demand curves to derive market demand.
  • The availability and cost of credit
  • Changes in the prices of related goods (substitutes and complements)
  • Population size and composition
  • Expectations
  • Change in education level
  • Change in the geographical situation of buyers - in the basic model there are no barriers to entry and consumers and factors of production possess instantaneous mobility.
  • Change in climate or weather - e.g. the demand for umbrellas increases when rain is predicted. However, this illustrates the constant shifting from practice to theory and back where the assumptions of the model are relaxed whenever necessary or convenient. A basic assumption of the standard model is that all economic factors have perfect knowledge so a consumer would never leave home without an umbrella on days when it rained.

[edit] Changes that increase demand

Some circumstances which can cause the demand curve to shift out include:

  • increase in price of a substitute
  • decrease in price of complement
  • increase in income if good is a normal good
  • decrease in income if good is an inferior good

[edit] Changes that decrease demand

Some circumstances which can cause the demand curve to shift in include:

  • decrease in price of a substitute
  • increase in price of a complement
  • decrease in income if good is normal good
  • increase in income if good is inferior good

[edit] Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to the factors which can affect individual demand there are three factors that can affect market demand (cause the market demand curve to shift):

  • a change in the number of consumers,
  • a change in the distribution of tastes among consumers,
  • a change in the distribution of income among consumers with different tastes. [5]

[edit] Movement along a demand curve

There is movement along a demand curve when a change in price causes the quantity demanded to change[3]. It is important to distinguish between movement along a demand curve, and a shift in a demand curve. Movements along a demand curve happen only when the price of the good changes.[6] When a non-price determinant of demand changes the curve shifts. These "other variables" are part of the demand function. They are "merely lumped into intercept term of a simple linear demand function." [7]

Demand is the quantity of goods a consumer is willing and able to buy under the prevailing circumstances. One circumstance is the price. There are many other circumstances that can affect this decision - the price of related goods, income, population, tastes, weather, even the price of tea in China to name a few. The demand curve is a two dimensional depiction of the relationship between the good's own price and the quantity demanded of the good. Since we have only two dimensions the line only shows the relationship between two of the many variables. The rest of the variables that can affect demand are being held constant; that is, they are reflected in the constant term, the intersection of the curve and the x axis. If one of these variables changes the constant term will change meaning the curve will shift in or out along the x axis. It is this shift that is called a change in demand. It is a change in demand because the shifted curve is not merely the old curve in a new position it is a new demand function.

[edit] Discreteness of amounts

If a commodity is sold in whole units, and these are substantial for a consumer, then the individual demand curve can hardly be approximated by a continuous curve. It is a step function of the price, defined by a price above which no unit is bought, a price range for which one is bought etc.

A basic assumption of the standard model is that goods are infinitely divisible - goods and servie production are flow concepts rather than stocks - as mentioned elsewhere the analogy would be a person measuring the rate of flow at at point on a river - x gallons per minute.

[edit] 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 how much the quantity will change in percentage terms for a 1% change in the price. As noted previously the formula for calculating PED is :(∂Q/∂P) (P/Q). [edit]

[edit] 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). [4]The greater the incentive the consumer has to delay consumption and search for substitutes and the more readily available substitutes are the more elastic the demand will be. Specific factors are:
Availability of Substitutes: The more choices that are available, the more elastic is the demand for a good. If the price of Pepsi goes up by 20%, one can always purchase Coke, 7-Up, Dr. Pepper and so forth. One's willingness and ability to postpone the consumption of Pepsi and get by with a "lesser brand" makes the PED of Pepsi relatively elastic.
Necessity: With a true necessity a consumer has neither the willingness nor the ability to postpone consumption. There are few or no satisfactory substitutes. Insulin is the ultimate necessity.
Proportion of Income Spent on a Good: Most consumers have both the willingness and ability to postpone the purchase of big ticket items. If an item constitutes a significant portion of one's income, it is worth one's time to search for substitutes. A consumer will give more time and thought to the purchase of a $3000 television than a $1 candy bar.
Duration: The more time a consumer has to search for substitute goods, the more elastic the demand.
Breadth of definition: How specifically the good is defined. For example, the demand for automobiles is more elastic than the demand for Toyotas which is in turn greater than the demand for Red Toyota Priuses.
Availability of Information Concerning Substitute Goods: The easier it is for a consumer to locate the substitute goods, the more willing he will be to undertake the search.

[edit] Interpreting Price Elasticities of Demand

The coefficient of elasticity indicates how sensitive the demand for a good is to a price change.[5] If the PED is between zero and 1 demand is said to be inelastic, if PED equals 1, the demand is unitary elastic and if the PED is greater than 1 demand is elastic. A low coefficient implies that changes in price have little influence on demand.[6] A high elasticity indicates that consumers will respond to a price rise that buying a lot less of the good and that consumers will will respond to a price cut buy a lot more "[7]

[edit] Taxes and subsidies

A sales tax on the commodity does not directly change the demand curve, if the price axis in the graph represents the price including tax. Similarly, a subsidy on the commodity does not directly change the demand curve, if the price axis in the graph represents the price after deduction of the subsidy.

If the price axis in the graph represents the price before addition of tax and/or subtraction of subsidy then the demand curve moves down when tax is introduced, and up when subsidy is introduced.

[edit] See also

[edit] References

  1. ^ a b O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 81-82. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 
  2. ^ Krugman, Paul, and Wells, Robin. Microeconomics. Worth Publishers, New York. 2005.
  3. ^ a b c Case, K.E., Fair, R.C. (1994). 'Demand, Supply, and Market Equilibrium', Chapter 4 in Principles of Economics, 3rd ed., Prentice Hall Englewood Cliffs, New Jersey
  4. ^ http://www.harpercollege.edu/mhealy/eco212i/lectures/s&d/s&d.htm
  5. ^ Binger, B & Hoffman, E.: Microeconomics with Calculus, 2nd ed. Addison-Wesley 1998. A change in relative price changes the distribution of income which in turn changes the demand curve.
  6. ^ Underwood, Instructor’s Manual, Microeconomics 5th ed. (Prentice-Hall 2001) at 5.
  7. ^ Underwood, Instructor’s Manual, Microeconomics 5th ed. (Prentice-Hall 2001) at 5.
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