Now we arrive at one of the basic building blocks of economics, demand. So what is demand?
“Demand: the various quantities of a good or service that consumers are willing and able to purchase over a range of prices during a specified period of time,” you say.
Fantastic. Looks like someone has been reading ahead.
Since that was a bit of a mouthful (that’s what she said), let’s break down the definition to figure out what it means. There are four important parts that I want to highlight.
This part is a bit obvious. Demands refers to people like you, me, and the guy down the street who are buying things. We, the consumers, are on the receiving end of the transaction.
Willing and Able
Like I mentioned in the Five Fundamental Questions of Economics, the ones who get the output are the ones who are both willing and able to purchase that product or service. Just because you want something really badly doesn’t mean you can have it; you need to have the means to pay for it. So when talking about demand, we’re only referring only to those who are willing and able to buy whatever it is that we’re looking at.
Various Quantities, Range of Prices
Demand refers to not just one price, but an entire series of prices and how much would be purchased at each of those corresponding prices. Note that demand by itself does not tell you what the market price for the good or service is; it only tells you what consumers are intending to buy at each price point.
Specified Period of Time
Demand without a time constraint is meaningless. Are we looking at how much consumers are willing to buy per week? Hour? Year? Without the time frame, there’s no way to tell if the demand is large or small.
The easiest way to be able to wrap your mind around all of this is to take a look at an example. Let’s look at Greg’s demand for pounds of bacon per week. I can illustrate his demand in three different forms: as an equation, a table, or a chart. (Remember that we’re talking about quantities and prices, so those are our two variables.)
Note: Demand curves aren’t always necessarily straight lines. This one just happens to be in this case to make our lives easier.
The equation, table, and graph all tell the same story. Let’s start with the table. This table shows how much bacon Greg will buy at any given price. When the price per pound of bacon is $10, Greg won’t buy any bacon at all, when it’s at $8, he’ll buy 10 pounds, and when it’s at $2, he’ll buy 20 pounds of bacon a week, so on and so forth. (Greg really loves his bacon.) Like I mentioned earlier, demand by itself does not show you what the prevailing market price is. Just by looking at the table or graph, we can’t tell how much bacon actually costs at the moment; all we can see is how much bacon Greg is willing and able to buy at any particular price.
“Hey, the numbers on the table look like they’re moving in opposite directions,” you notice.
That’s absolutely correct. As the price of bacon goes up, the amount that Greg is willing to buy goes down. As the price goes down, the amount of bacon Greg is willing to buy goes up. In other words, there is an inverse (or negative) relationship between price and quantity demanded and we economists call this relationship the law of demand.
The law of demand states that all else equal, as price increases, quantity demanded decreases and as price decreases, quantity demanded increases. You can easily see this relationship in the graph because the line is downward sloping and in the equation because the slope is negative.
Why would this be the case? Let’s think about it.
Diminishing Marginal Utility
One thing to consider is the satisfaction that we get when consuming something. In general, the more of something we have, the less satisfaction we get each successive time we consume it during a given time period. For example, the second taco that you eat right after the first one isn’t quite as good as the first. The third taco isn’t going to be quite as good as the second, so on and so forth. We call this concept diminishing marginal utility. At some point, the cost of tacos will be greater than the satisfaction or benefit you derive from consuming them and so you’ll stop buying them. The higher the price, the faster you reach this threshold, the less you consume and vice versa.
If our income rises, we are able to purchase more of a good or service. Similarly, when the price for a good or service falls, we’re able to purchase more of that good or service. Thus, a fall in price for a good or service creates the perception of an increase in income. We call that perception change the income effect. It’s an effect because income itself hasn’t actually changed. When the price increases, the income effect causes us to purchase less of that good and service (because we feel poorer) and when the price increases, the income effect causes us to purchase more of that good or service (because we feel richer).
Changing the price of a particular good also changes the relative prices of its substitutable goods. For example, if the price of beef goes up, the relative price of chicken goes down (even though the actual price of chicken hasn’t changed). Because of that, we become inclined to buy more chicken and less beef. The opposite is also true: a decrease in the price of beef makes beef relatively less expensive, resulting in the purchase of more beef and less chicken. This is called the substitution effect because deals with goods/services you could use to substitute for your original good or service.
It’s a combination of these effects that cause the demand curve to slope downwards.
Thus far, we’ve taken a look at the demand schedule for a single person. But when economists analyze the demand for a product, they don’t look at the demand for just one individual; they look at the entire market. To go from an individual’s demand to the market’s all we have to do is total the quantity the consumers are willing to purchase at every price point and create a new schedule from that. Graphically all you’re doing is horizontal summation; for every Y value, you’re adding up all the corresponding X values to come up with a new X value.
And with that you now understand the basics of the demand curve. Our journey is far from over though. In my next post, I’ll go over what happens when we break the all else equal assumption and allow things other than price to change.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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