The demand for a good depends on several factors, such as price of the good, perceived quality, advertising, income, confidence of consumers and changes in taste and fashion.
We can look at either an individual demand curve or the total demand in the economy.
- The individual demand curve illustrates the price people are willing to pay for a particular quantity of a good.
- The market demand curve will be the sum of all individual demand curves. It shows the quantity of a good consumers plan to buy at different prices.
1. Change in price
A change in price causes a movement along the Demand Curve.
For example, if there is an increase in price from $12 to £16 then there will be a fall in demand from 80 to 60.
How important is price?
Some goods are more affected by price than others.
- If petrol increases in price, because it is a necessity, there is only a small fall in demand (we say it is inelastic demand).
- If Volvic water increases in price, there will be a significant fall in demand because people buy cheaper substitutes (demand is elastic)
Shifts in the demand curve
This occurs when, even at the same price, consumers are willing to buy a higher (or lower) quantity of goods. This will occur if there is a shift in the conditions of demand.
For example, if there is an increase in price from $12 to £16 then there will be a fall in demand from 80 to 60.
How important is price?
Some goods are more affected by price than others.
- If petrol increases in price, because it is a necessity, there is only a small fall in demand (we say it is inelastic demand).
- If Volvic water increases in price, there will be a significant fall in demand because people buy cheaper substitutes (demand is elastic)
Shifts in the demand curve
This occurs when, even at the same price, consumers are willing to buy a higher (or lower) quantity of goods. This will occur if there is a shift in the conditions of demand.
A fall in demand could occur due to lower disposable income or decline in the popularity of the good.
Evaluation
- For some luxury goods, income will be an important determinant of demand. e.g. if your income increased you would buy more restaurant meals, but probably not more salt.
- Advertising is important for goods in which branding is important, e.g. soft drinks but not for bananas.
Video on demand
Effective demand
- Effective demand: This occurs when a consumers desire to buy a good can be backed up by his ability to afford it.
Effective demand refers to the willingness and ability of consumers to purchase goods at different prices. It shows the amount of goods that consumers are actually buying – supported by their ability to pay.
Effective demand excludes latent demand – where the willingness to purchase goods may be limited by the inability to afford it – or lack of knowledge.
In Keynes’s macroeconomic theory, effective demand is the point of equilibrium where aggregate demand = aggregate supply. The importance of Keynes’ view is that effective demand may be insufficient to achieve full employment due to unemployment and workers without income to produce unsold goods.
Demand curve showing individual’s effective demand
In this case, the consumer will be willing and able to purchase 22 goods when the price is £12.
Factors affecting effective demand
The main factors affecting ‘effective demand’ will be
- Price
- Income – a rise in income will tend to cause rising demand.
- Availability of credit. If consumers and firms are able to borrow, then they have an effective demand to buy or invest. If credit is constrained, their effective demand is limited by the lack of access to credit.
See also: Factors affecting demand
Effective demand in Keynes’ General Theory
David Ricardo and John Baptiste Say held the view that “Supply creates its own demand” (this is the simplification of Keynes). In other words, if supply increases, the demand will be there.
However, in looking at the Great Depression, Keynes argued that effective demand could be less than necessary to achieve equilibrium. If demand falls, it can create a negative multiplier effect which causes unemployed resources. In Keynes theory, the level of ‘effective aggregate demand’ determines equilibrium national income.
The level of effective demand will be where the aggregate demand curve equals aggregate supply
Keynes argued there may be a case to boost effective demand
Latent demand
Demand is said to be latent if consumers would like to be able to purchase the good. For example, usually, a consumer would buy three loaves of bread per week. But, if he has an unexpected drop in income, he may not be able to afford the loaves. When his income returns to normal, his latent demand will return to effective demand.
Also, a new medicine could have a strong latent demand, but because people are not aware of its efficacy, they don’t buy. If there is a better knowledge of the good, then that latent demand will be realised.
Many firms can tap into latent demand for luxury goods by offering enticing credit deals – where the consumer can buy the goods on credit. 0% interest-free deals can be an effective way of turning latent demand into effective demand.
Example of effective demand
Students who have sufficient income or wealthy parents can effectively demand university education. Students with no parental backing may not have the effective demand to study at university.
Effective demand and derived demand
Derived demand occurs when there is demand for a good or service depending on demand for an intermediary. For example, demand for a peak railcard is dependent on demand for labour. With economic growth, there is a greater derived demand for transport for two reasons.
With higher pay, we now have more income and see a rise in our ability to pay (effective demand). Also, we need transport in order to get to work. If we are unemployed we cannot afford to travel around the country
Derived Demand
- Derived demand: This occurs when a good or factor of production such as labour is demanded for another reason
Derived demand occurs when there is a demand for a good or factor of production resulting from demand for an intermediate good or service.
Example – mobile phones and lithium batteries
The rise in demand for mobile phones and other mobile devices has led to a strong rise in demand for lithium. Lithium is used in the batteries.
Higher demand for mobile phones has caused greater demand for lithium batteries.
Derived demand – direct and indirect
The increase in demand for mobile phones will also cause derived demand for other components such as glass screens and micro-chips.
Indirectly, a rise in demand for mobile phones may cause a rise in demand for retail premises (to sell them). There will also be derived demand for energy/transport and even food services in the location where phones are produced sold.
Example of Labour as Derived Demand
In this case, greater demand for buying coffee leads to greater demand for baristas (coffee-makers)
The demand for economic tutors depends on the demand for students wishing to study economics. If students sign up for an economics course, then the college will demand tutors to be able to teach the students.
The demand for coal workers is highly dependent upon the demand for coal. As the demand for British coal fell in the 1980s, demand for coal miners declined.
Marginal Revenue Product Theory
Marginal Revenue Product Theory states that demand for labour depends upon the productivity of a worker and the marginal revenue of the goods sold. MRP = MPP * MR
- MPP = Marginal physical product
- MR = Marginal Revenue of goods sold
If demand for the good increase, the price and MR will increase leading to higher demand.
Transport as Derived Demand
Demand for transport tends to be determined by the demand for another service/activity. If people need to get to work, they will demand more bus journeys. Few people take a bus for the intrinsic pleasure of a bus journey.
Demand for car travel in the UK is closely related to economic growth. WIth more economic activity, there is greater demand for travelling by car.
Similar concept – Joint Demand / Complementary Demand
This occurs when two goods are needed together. For example,
- Mp4 downloads and an iPod player.
- A tennis ball and a tennis racket.
Giffen Good Definition
- A Giffen good is a good where an increase in price of a basic item leads to an increase in demand, because very poor people cannot afford any other luxury goods.
Definition of a Giffen Good. A good where a higher price causes an increase in demand (reversing the usual law of demand). The increase in demand is due to the income effect of the higher price outweighing the substitution effect.
- The concept of a Giffen good is limited to very poor communities with a very limited choice of goods. Empirical evidence is hard to find, though some economists thought it applied to the Victorian poor who had a very limited diet.
The idea is that if you are very poor and the price of your basic foodstuff (e.g. bread) increases, then you can’t afford the more expensive alternative food (meat) therefore, you end up buying more bread because it is the only thing you can afford.
“As Mr.Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.
—Alfred Marshall, Principles of Economics (1895 ed.)
Suppose you have a very low income and eat two basic foodstuffs rice and meat.
- Meat is a luxury and is much more expensive than rice.
- If rice increased in price, your disposable income is effectively reduced significantly.
- Therefore, with a reduction in disposable income – you buy less meat
- To compensate for less meat, you buy more rice to gain enough calories.
It is quite rare and whether it really happens has a little uncertainty. But, it shows that there are two factors affecting demand price (substitution effect) and income.
With a Giffen good, if rice continues to rise in prices, demand may eventually fall because the poor workers will not be able to even afford rice.
Diagram of Giffen good
Readers question: This post reminded me of a similar situation: a Giffen good. In fact, Veblen goods and Giffen goods seem to be extremely similar, and I was hoping you could clarify the difference between the two!
The law of demand says a higher price leads to lower demand. However, there are two exceptions
- Veblen Good. In this post, we defined a Veblen Good (sometimes known as ostentatious good). The basic principle is that as price rises people buy more. This is because people think if it is more expensive it must be better quality. This is possible for some designer clothes e.t.c. WIth a Veblen good, the demand curve is shifting to the right – rather than demand upwardly sloping like Giffen good.
- Giffen Good. A Giffen good has the same affect – higher price leads to higher demand. But, it is for a completely different reason. A Giffen good occurs when a rise in price causes higher demand because the income effect outweighs the substitution effect.
Indifference curve analysis and Giffen Goods
We start at Q2, the rise in the price of rice, reduces the budget line for rice to B2. But, the fall in income causes a large income effect that outweighs the substitution effect. Demand for rice rises to Q3 with a big fall in demand for meat.
Snob / Ostentatious Good
- An ostentatious good, is a good where an increase in price leads to an increase in demand because people believe it is now better.
Readers Question: What is the name of a type of good that only has value to someone if no one else possesses it?
A snob or ostentatious good is a good where the main attraction is related to its image of being expensive, exclusive and a symbol of social status. These goods will have restricted supply and only be available to people with high income.
A snob good is very similar in principle to a Veblen Good This is a good where demand is often greater when the price is higher. It is a good people consume because it is seen as exclusive and therefore a symbol of social status/wealth. A reduction in the price of the good may make it less attractive because it would no longer be seen as socially exclusive and indicative of social standing.
Diagram of snob/obstentatious good
This contradicts the basic low of demand. At a higher price, it becomes more desirable. It is complicated by the fact that although desired demand may be higher at a higher price, the effective demand (enough income) may off-set the greater desirability. So in practice, a snob good may not have an upward sloping demand, but perhaps very price inelastic.
Examples of snob/ostentatious goods
Goods that are often used as a sign of social and personal status. They may include
- Famous brand named handbags, e.g a Gucci Zumi small embellished alligator shoulder bag which retails for £22,280.00
- Exclusive watches, e.g. Patek Phillipe Grand Complications Split-Seconds Chronograph Perpetual Calendar for £199,000.
- Expensive and rare artwork, e.g. modern art with limited print runs, e.g artwork of Jeff Koons.
Another term is conspicuous consumption or status-seeking. These are goods we buy in order to ‘keep up with the Jones’. The good may give little actual utility apart from the pride of owning something very few other people own.
How Veblen Goods Can Make Society Worse off
Prof Eaton, of the University of Calgary, and Prof Eswaran, of the University of British Columbia, recently found that rising wealth in an economy increases the demand for Veblen Goods. In periods of rising prosperity, such ostentatious goods become more important There is an element of a ‘bandwagon effect’. If we see other people having a certain good there is a desire to also own such a good.
However, because these Veblen goods are very expensive, only a small % can afford them. This makes the majority of the population feel worse off. Although real living standards have increased, they can’t afford many of these exclusively / desirable goods.
The other issue of Veblen goods is that they rarely have any intrinsic value, other than to show off to other people. Diamonds, luxury cars and luxury handbags give little economic utility other than the social prestige of owning them.
The nature of Veblen goods means that only a small % of the population can afford them. Therefore, rising wealth tends to increase the price of these ostentatious goods disproportionately to make sure only a small % can still afford them. Therefore economic growth cannot solve the problem of Veblen goods. Their price will always rise to make sure a small % of the population can afford them.
This might explain at least part of the rapid rise in the price of ‘exclusive modern artworks’
Of course, the alternative is to take a different viewpoint and desire goods for the intrinsic value they give rather than seeking to impress the Jones’.
Composite Demand – definition and examples
Definition of composite demand
Demand for a good that has multiple different uses. e.g. People may demand oil because it can be used to create either petrol or plastics.
Examples of composite demand
- People may demand wheat for producing bread, biofuels or feeding livestock.
- Land can be used for farming or building houses.
- Steel could be used for building tanks or it could be used for building bicycles.
- Demand for new iPhone – to use as a camera, access the internet and make phone calls.
Impact of composite demand
When a good like wheat has different uses, there can be a rationing effect. If demand for biofuel goes up, then the price of wheat for bread will also rise. More people demanding wheat for biofuels limits the availability of wheat for making bread.
If we build more houses, it leaves less land for farming and the price of farming land will tend to rise.
Joint Demand
- Joint demand – goods bought together e.g. printer and printer ink.
Definition
Joint demand occurs when demand for two goods is interdependent. For example, it is no good having a printer without the ink to go with it. Similarly, ink cartridges are no use without a printer. Another example could be a razor and razor blades.
Basically, the definition of joint demand is when you need two goods to go together.
If two goods are in joint demand they will have a high and negative cross elasticity of demand. – A fall in the price of ink will lead to an increase in demand for printers.
If a consumer keeps a printer for three years, then he may buy 10 or 20 ink cartridges. If these ink cartridges are around £10, then ink cartridges could be quite profitable. Therefore, it could make sense for a company to sell a printer at a loss in order to encourage people to buy the printer. Once they have a particular brand of printer, they can make a high profit margin on selling compatible inks.
Some print companies go to great lengths to prevent other firms selling compatible inks. (e.g. electronic chips). This is because once you have bought a printer for £50. You will have to keep buying ink which goes with the printer.
Joint demand – two related markets
A fall in the price of printers will cause higher demand. but, will also cause higher demand for ink which is demanded jointly.
This practice is really anti-competitive. The market for printer ink should be investigated by the OFT. I have had personal experiences of buying a printer for £50 – thinking I had a good deal until I realised how expensive the ink was.
Sometimes this is known as ‘complementary demand’ e.g. Strawberries and cream are complements and so they are often bought together.
It is also related to the principle of derived demand. E.g. if the demand for economics lessons there will be an increase in demand for economic tutors.
Demand curve formula
The demand curve shows the amount of goods consumers are willing to buy at each market price.
A linear demand curve can be plotted using the following equation.
Qd = a – b(P)
- Q = quantity demand
- a = all factors affecting price other than price (e.g. income, fashion)
- b = slope of the demand curve
- P = Price of the good.
Inverse demand equation
The inverse demand equation can also be written as
- P = a -b(Q)
- a = intercept where price is 0
- b = slope of demand curve
Example of linear demand curve
Qd = 20 – 2P
| Q | P |
| 40 | 0 |
| 38 | 1 |
| 36 | 2 |
| 34 | 3 |
| 32 | 4 |
| 30 | 5 |
| 28 | 6 |
| 26 | 7 |
| 0 | 20 |
Change in a
In this case, a has increased from 40 to 50.
This means that for the same price, demand is greater. It reflects a shift in the demand curve to the right. This could be due to a rise in consumer income which enables them to buy more goods at each price.
Change in b
In this case, the equation has changed from Q=40-2P to Q= 40-1P
This means the slope is steeper and looks like this.
https://bit.ly/3Clnnhu
