Basically, I'm back to cover a very basic principle of microeconomics: Demand. Demand refers to the amount consumers can and are able to purchase of a good or service, 'can and able' being a very important part. Note that a consumers want for a good should not be included in demand. I'm sure everyone wants a flashy sports car on their drive yet the true demand of that good will be very small. Glad we got that out of the way. The demand of a good in a market plays a pivotal role in determining the price. For this, demand must interact with supply and the point at which they meet can be called the 'market output' or the 'equilibrium output'. This is displayed on a graph which I'll do a post about in a few days. The price at this 'equilibrium output' is called the 'market price' or the 'equilibrium price' which is essentially the price consumers have to pay for the good and the price suppliers are selling at.
It's important for me to point out here also that when looking at demand we assume that we're operating in a market of perfect competition. This basically means that in the market there are an abundance of consumers and producers and therefore they have no control over prices. We call them price takers. The size of each producer is too small and there is too much competition from other firms that it would be impossible for them to raise prices and still make sales. Perfect competition is the closest theoretical example to most real-world markets and therefore we use it in our examples.
Let's now look at the relationship between the demand and the price of a good or service. The law of demand is as such: 'When the price of a good rises, the quantity demanded will fall'. This occurs for two reasons:
- The good/service will cost more than substitute goods. Other similar products will be comparatively cheaper and therefore demand for the good will fall as consumers start to purchase the substitute. For example, a Playstation 3 could be said to be a substitute good for an Xbox 360. Therefore, if the price of the Xbox 360 were to rise then the demand for it would fall as consumers move over to purchase the comparatively cheaper Playstation 3. This is called the 'substitution effect' of a rise in price.
- People will feel poorer. A rise in the price of a good means people will effectively be able to afford less of the good which makes them seem less well-off, or poorer. This is known as the 'income effect' of a price rise.
- Tastes - The more desirable a good the more it will be demanded and vice versa. This is often affected by advertisements, fashions and what other consumers are purchasing.
- Quantity and Price of Substitute Goods - If a substitute good has a higher price then demand for the good in question will be higher. If the substitute good has a lower price then the demand will be lower for the initial good.
- Quantity and Price of Complimentary Goods - This works in the opposite way to above. Complimentary goods are products that are consumed together, examples would be cars and petrol or DVD players and the actual DVDs. If the complimentary good's price rises you can expect the demand for the good in question to fall and vice versa.
- Income - This one is fairly obvious. As people's incomes rise, so does their spending power and therefore demand for 'normal' goods will rise. With this, demand for 'inferior' goods will fall. When we say 'inferior' goods we are talking about things such as supermarket own brand foods.
- Distribution of Incomes - This determinant is a little more ambiguous. If wealth was re-distributed from the rich to the poor, then demand for luxury items would rise as the poorer people would be able to buy these goods for the first times. It works in the opposite way too, if the poor in society get poorer then the demand for 'normal' goods will fall as the demand for 'inferior' goods should rise.
- Expectations - Last but not least, people's expectations. Everyone speculates, and if the speculation is that the price of a good is set to rise in the near future then we can expect demand to rise in the short term. If the price is expected to fall we'd expect demand to fall as people hold out until the lower price arrives.
- A change in price results in a movement along the demand curve.
- A change in a non-price determinant results in a shift of the demand curve.
The proper names for these two principles are as follows:
- A shift in the demand curve is called a change in demand.
- A movement along the demand curve is called a change in the quantity demanded.